Reporting and Interpreting Bonds

Transcription

1 Reporting and Interpreting Bonds CHAPTER 10 McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, Inc.

2 Not Barry and not James Slide 2

3 Understanding the Business The mixture of debt and equity used to finance a company s operations is called the capital structure: Debt - funds from creditors Equity - funds from owners Slide 3

4 Characteristics of Bonds Payable Advantages of bonds: Stockholders maintain control because bonds are debt, not equity. Interest expense is tax deductible. The impact on earnings is positive because money can often be borrowed at a low interest rate and invested at a higher interest rate. Slide 4

5 Characteristics of Bonds Payable Disadvantages of bonds: Risk of bankruptcy exists because the interest and debt must be paid back as scheduled or creditors will force legal action. Negative impact on cash flows exists because interest and principal must be repaid in the future. Slide 5

6 Characteristics of Bonds Payable Face Value $1,000 Interest 10% BOND PAYABLE 6/30 & 12/31 Bond Date 1/1/09 Maturity Date 1/1/19 1. Face Value (Maturity or Par Value, Principal) 2. Maturity Date Other Factors: 3. Stated Interest Rate 6. Market Interest Rate 4. Interest Payment Dates 7. Issue Date 5. Bond Date McGraw-Hill/Irwin Slide 6

7 McGraw-Hill/Irwin Slide 7

8 Bond Classifications An indenture is a bond contract that specifies the legal provisions of a bond issue. Debenture bonds Not secured with the pledge of a specific asset. Callable bonds May be retired and repaid (called) at any time at the option of the issuer. Convertible bonds May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder. McGraw-Hill/Irwin Slide 8

9 Characteristics of Bonds Payable When issuing bonds, potential buyers of the bonds are given a prospectus. The prospectus describes the company, the bonds, and how the proceeds of the bonds will be used. The trustee makes sure the issuer fulfills all of the provisions of the bond indenture. Slide 9

10 Characteristics of Bonds Payable Company Issuing Bonds Periodic $ Interest Bond Issue Payments Price $ $ $ Bond Principal Certificate Payment at End of Bond Term $ $ Bonds payable are long-term debt for the issuing company. Investor Buying Bonds McGraw-Hill/Irwin Slide 10

11 Reporting Bond Transactions Present Value of the Principal (a single payment) + Present Value of the Interest Payments (an annuity) = Issue Price of the Bond Interest Rates Bond Price Accounting for the Difference Stated Market Bond Par Value There is no difference = = Rate Rate Price of the Bond to account for. Stated < Market Bond < Par Value The difference is accounted Rate Rate Price of the Bond for as a bond discount. Stated > Market Bond > Par Value The difference is accounted Rate Rate Price of the Bond for as a bond premium. McGraw-Hill/Irwin Slide 11

12 Bonds Issued at Par On January 1, 2009, Harrah s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is paid semiannually. The market rate is 10% annually. This bond is issued at a par. GENERAL JOURNAL Date Interest Description Bond Accounting Debit for Credit Jan Rates 1 Cash (+A) Price the 100,000 Difference Stated Market Bonds Bond Payable Par (+L) Value There is no difference 100,000 = = Rate Rate Price of the Bond to account for. McGraw-Hill/Irwin Slide 12

13 Bonds Issued at Par Here is the entry made every six months to record the interest payment. GENERAL JOURNAL Date Description Debit Credit Bond Interest Expense (+E, -SE) 5,000 Cash (-A) 5,000 Here is the entry to record the maturity of the bonds. GENERAL JOURNAL Date Description Debit Credit Bonds Payable (-L) 100,000 Cash (-A) 100,000 McGraw-Hill/Irwin Slide 13

14 Times Interest Earned Times Interest Earned = Net income + Interest expense + Income tax expense Interest expense The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio. McGraw-Hill/Irwin Slide 14

15 Bonds Issued at Discount On January 1, 2009, Harrah s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. Interest Bond Accounting for Rates Price the Difference Stated < Market Bond < Par Value The difference is accounted Rate Rate Price of the Bond for as a bond discount. McGraw-Hill/Irwin Slide 15

16 Bonds Issued at Discount The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) First, let s compute the present value of the principal. Market rate of 12% 2 interest periods per year = 6% Use the present value of a single amount table to find the appropriate factor. Bond term of 10 years 2 periods per year = 20 periods Present Value Single Amount = Principal Factor (i=6.0%, n=20) $ 31,180 = $ 100, McGraw-Hill/Irwin Slide 16

17 Bonds Issued at Discount The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) Now, let s compute the present value of the interest. Market rate of 12% 2 interest periods per year = 6% Use the present value of an annuity table to find the appropriate factor. Bond term of 10 years 2 periods per year = 20 periods Present Value Annuity = Payment Factor (i=6.0%, n=20) $ 57,350 = $ 5, McGraw-Hill/Irwin Slide 17

18 Bonds Issued at Discount The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) Finally, we can determine the issue price of the bond. $ 31,180 Present Value of the Principal + 57,350 Present Value of the Interest = $ 88,530 Present Value of the Bonds The $88,530 is less than the face amount of $100,000, so the bonds are issued at a discount of $11,470. McGraw-Hill/Irwin Slide 18

19 Bonds Issued at Discount Here is the journal entry to record the bond issued at a discount. GENERAL JOURNAL Date Description Debit Credit Jan 1 Cash (+A) 88,530 Discount on Bonds Payable (+XL, -L) 11,470 Bonds Payable (+L) 100,000 This is a contra-liability account and appears in the liability section of the balance sheet. McGraw-Hill/Irwin Slide 19

20 Bonds Issued at Discount Harrah's Partial Balance Sheet At January 1, 2009 Long-Term Liabilities Bonds Payable, 10% $ 100,000 Due Dec. 31, 2018 Less: Bond Discount (11,470) Total L-T Liabilities $ 88,530 The discount will be amortized over the 10- year life of the bonds. Two methods of amortization are commonly used: Straight-line Effectiveinterest. McGraw-Hill/Irwin Slide 20

21 Reporting Interest Expense: Effective-interest Amortization The effective interest method is the theoretically preferred method. Compute interest expense by multiplying the current unpaid balance times the market rate of interest. The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest. McGraw-Hill/Irwin Slide 21

22 Reporting Interest Expense: Effective-interest Amortization Harrah s issued their bonds on Jan. 1, The issue price was $88,530. The bonds have a 10- year maturity and $5,000 interest is paid semiannually. Unpaid Balance Effective Interest Rate n / 12 Compute the periodic discount amortization using the effective interest method. $88,530 12% 1 / 2 = $5,312 Discount Total Cash Paid Amortization = Interest - for Interest $ 312 = $ 5,312 - $ 5,000 McGraw-Hill/Irwin Slide 22

23 Reporting Interest Expense: Effective-interest Amortization GENERAL JOURNAL Date Description Debit Credit Jun 30 Interest Expense (+E, -SE) 5,312 Discount on Bonds Payable (-XL, +L) 312 Cash (-A) 5,000 Harrah's Partial Balance Sheet At June 30, 2009 Long-Term Liabilities Bonds Payable, 10% $ 100,000 Due Dec. 31, 2018 Less: Bond Discount (11,158) Total L-T Liabilities $ 88,842 As the discount is amortized, the carrying amount of the bonds increases. McGraw-Hill/Irwin Slide 23

24 Effective-Interest Amortization Table Interest Interest Discount Unamortized Book Date Payment Expense* Amortization* Discount* Value 1/1/2009 $ 11,470 $ 88,530 6/30/2009 $ 5,000 $ 5,312 $ ,158 88,842 12/31/2009 5,000 5, ,828 89,172 6/30/2010 5,000 5, ,477 89,523 12/31/2010 5,000 5, ,106 89,894 6/30/2011 5,000 5, ,712 90,288 12/31/2011 5,000 5, ,295 90, /30/2018 5,000 5, ,056 12/31/2018 5,000 5, ,000 $ 100,000 $ 111,470 $ 11,470 * Rounded. McGraw-Hill/Irwin Slide 24

25 Zero Coupon Bonds Zero coupon bonds do not pay periodic interest. Because there is no interest annuity... PV of the Principal = Issue Price of the Bonds This is called a deep discount bond. McGraw-Hill/Irwin Slide 25

26 Bonds Issued at Premium On January 1, 2009, Harrah s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. Interest Bond Accounting for Rates Price the Difference Stated > Market Bond > Par Value The difference is accounted Rate Rate Price of the Bond for as a bond premium. McGraw-Hill/Irwin Slide 26

27 Bonds Issued at Premium The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) First, let s compute the present value of the principal. Use Market the present rate of 8% value 2 interest of a single periods amount per year table = 4% to find the appropriate factor. Bond term of 10 years 2 periods per year = 20 periods Present Value Single Amount = Principal Factor (i=4.0%, n=20) $ 45,640 = $ 100, McGraw-Hill/Irwin Slide 27

28 Bonds Issued at Premium The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) Now, let s compute the present value of the interest. Use Market the present rate of 8% value 2 interest of an periods annuity per table year to = 4% find the appropriate factor. Bond term of 10 years 2 periods per year = 20 periods Present Value Annuity = Payment Factor (i=4.0%, n=20) $ 67,952 = $ 5, McGraw-Hill/Irwin Slide 28

29 Bonds Issued at Premium The issue price of a bond is composed of the present value of two items: Principal (a single amount) Interest (an annuity) Finally, we can determine the issue price of the bond. $ 45,640 Present Value of the Principal + 67,952 Present Value of the Interest = $ 113,592 Present Value of the Bonds The $113,592 is greater than the face amount of $100,000, so the bonds are issued at a premium of $13,592. McGraw-Hill/Irwin Slide 29

30 Bonds Issued at Premium GENERAL JOURNAL Date Description Debit Credit Jan 1 Cash (+A) 113,592 Premium on Bonds Payable (+L) 13,592 Bonds Payable (+L) 100,000 Harrah's This is an adjunct-liability account and appears Partial Balance Sheet in the liability section of the balance sheet. At January 1, 2009 Long-Term Liabilities Bonds Payable, 10% $ 100,000 Due Dec. 31, 2018 Add: Bond Premium 13,592 Total L-T Liabilities $ 113,592 The premium will be amortized over the 10- year life of the bonds. McGraw-Hill/Irwin Slide 30

31 Straight-Line Amortization Table Interest Interest Premium Unamortized Book Date Payment Expense* Amortization* Premium* Value 1/1/2009 $ 13,592 $ 113,592 6/30/2009 $ 5,000 $ 4,320 $ , ,912 12/31/2009 5,000 4, , ,233 6/30/2010 5,000 4, , ,553 12/31/2010 5,000 4, , ,874 6/30/2011 5,000 4, , ,194 12/31/2011 5,000 4, , , /30/2018 5,000 4, ,680 12/31/2018 5,000 4, ,000 $ 100,000 $ 86,408 $ 13,592 * Rounded. McGraw-Hill/Irwin Slide 31

32 Reporting Interest Expense: Straight-line Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, GENERAL JOURNAL Date Description Debit Credit Jun 30 Interest Expense (+E, -SE) 4,320 Premium on Bonds Payable (-L) 680 Cash (-A) 5,000 McGraw-Hill/Irwin Slide 32

33 Effective-Interest Amortization Table Interest Interest Premium Unamortized Book Date Payment Expense* Amortization* Premium* Value 1/1/2009 $ 13,592 $ 113,592 6/30/2009 $ 5,000 $ 4,544 $ , ,136 12/31/2009 5,000 4, , ,661 6/30/2010 5,000 4, , ,168 12/31/2010 5,000 4, , ,654 6/30/2011 5,000 4, , ,120 12/31/2011 5,000 4, , , /30/2018 5,000 4, ,965 12/31/2018 5,000 4,039 * ,000 $ 100,000 $ 86,408 $ 13,592 * Rounded. McGraw-Hill/Irwin Slide 33

34 Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, GENERAL JOURNAL Date Description Debit Credit Jun 30 Interest Expense (+E, -SE) 4,544 Premium on Bonds Payable (-L) 456 Cash (-A) 5,000 McGraw-Hill/Irwin Slide 34

35 Debt-to-Equity Debt-to-Equity = Total Liabilities Stockholders Equity This ratio shows the relationship between the amount of capital provided by owners and the amount provided by creditors. In general, a high ratio suggest that a company relies heavily on funds provided by creditors. McGraw-Hill/Irwin Slide 35

36 Early Retirement of Debt Occasionally, the issuing company will call (repay early) some or all of its bonds. Gains/losses are calculated by comparing the bond call amount with the book value of the bond. Book Value > Retirement Price = Gain Book Value < Retirement Price = Loss McGraw-Hill/Irwin Slide 36

37 Focus on Cash Flows Financing Activities Issuance of bonds (a cash inflow) Retire debt (a cash outflow) Repay bond principal at maturity (a cash outflow) Remember that payment of interest is an operating activity. McGraw-Hill/Irwin Slide 37

38 End of Chapter The McGraw-Hill Companies, Inc.