Chapter 10

Reporting and
Interpreting Bonds
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Business Background
The mixture of debt and equity used to finance
a company’s operations is called the capital
structure:

Debt - funds Equity - funds

from creditors from owners

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Business Background
Capital Structure - Bonds
Significant
Significant debt
debt needs
needs of of aa
company
company areare often
often filled
filled
by
by issuing
issuing bonds.
bonds.

Bonds Cash

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Business Background

Bonds
Bonds can
can be be As liquidity
traded increases . . .
traded on
on
established
established
exchanges
exchanges that that
provide
provide
liquidity
liquidity to
to . . . Cost of
borrowing
bondholders.
bondholders. decreases.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Business Background
Advantages
Advantages of of bonds:
bonds:
•• Bonds
Bonds are
are debt,
debt, not
not equity,
equity, so
so the
the
ownership
ownership and and control
control ofof the
the
company
company are are not
not diluted.
diluted.
•• Interest
Interest expense
expense is is tax-deductible.
tax-deductible.
•• The
The low
low interest
interest rates
rates onon bonds
bonds
allow
allow for
for positive
positive financial
financial
leverage.
leverage.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Business Background
Disadvantages
Disadvantages of
of bonds:
bonds:
•• The
The scheduled
scheduled interest
interest
payments
payments are are legal
legal
obligations
obligations and
and must
must be
be paid
paid
each
each period.
period.
•• AA single,
single, large
large principal
principal
payment
payment is is required
required at
at the
the
maturity
maturity date.
date.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Key Ratio Analysis

The debt-equity ratio is an important

measure of the balance between debt and
equity.

Total
Total liabilities
liabilities
Debt/equity
Debt/equity ratio
ratio == Owners'
Owners' equity
equity

High debt-equity ratios indicate more

leverage and risk.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Characteristics of Bonds Payable
At Bond Issuance Date

$ Bond Issue Price $

Company
Company Investor
Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Bonds
Bonds
Bond Certificate

Bonds payable are long-term debt

for the issuing company.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Characteristics of Bonds Payable

Periodic
$ Interest Payments $
Company
Company Investor
Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Bonds
Bonds
Face Value
$ Payment at End of $
Bond Term

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Characteristics of Bonds Payable
Face Value $1,000 Interest 10%
6/30 & 12/31
BOND PAYABLE

Bond Date 1/1/01 Maturity Date 1/1/10

1. Face Value = Maturity or Par Value, Principal

2. Maturity Date
3. Stated Interest Rate Other Factors:
4. Interest Payment Dates 6. Market Interest Rate
5. Bond Date 7. Issue Date
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Characteristics of Bonds Payable

•• When
When issuing
issuing bonds,
bonds, potential
potential
buyers
buyers of of the
the bonds
bonds areare given
given aa
prospectus.
prospectus.
•• The
The company’s
company’s bonds bonds are
are issued
issued
to
to investors
investors through
through an an
underwriter.
underwriter.
•• The
The trustee
trustee makes
makes suresure the
the
issuer
issuer fulfills
fulfills all
all of
of the
the provisions
provisions
of
of the
the bond
bond indenture.
indenture.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bond Classifications

•• Debenture
Debenturebonds
bonds
Not
Notsecured
securedwith
withthe
thepledge
pledgeof
ofaaspecific
specificasset.
asset.
•• Callable
Callablebonds
bonds
May
Maybe beretired
retiredand
andrepaid
repaid(called)
(called)at
atany
anytime
timeat
atthe
theoption
option
of the issuer.
of the issuer.
•• Redeemable
Redeemablebonds
bonds
May
Maybebeturned
turnedin
inat
atany
anytime
timefor
forrepayment
repaymentat
atthe
theoption
optionof
of
the
thebondholder.
bondholder.
•• Convertible
Convertiblebonds
bonds
May
Maybebeexchanged
exchangedforforother
othersecurities
securitiesof
ofthe
theissuer
issuer
(usually
(usuallyshares
sharesof
ofcommon
commonstock)
stock)atatthe
theoption
optionof
ofthe
the
bondholder.
bondholder.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bond Classifications

•• Senior
Senior Debt
Debt receives
receives
preference
preference over
over other
other
creditors
creditors inin the
the event
event ofof
bankruptcy
bankruptcy or or default.
default.
•• Subordinated
Subordinated Debt Debt is
is
riskier
riskier than
than senior
senior debt.
debt.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Measuring Bonds Payable and
Interest Expense
The issue price of the bond is determined by
the market, based on the time value of money.

Present
PresentValue
Valueofofthe
thePrincipal
Principal (a
(asingle
singlepayment)
payment)
++ Present
PresentValue
Valueofofthe
theInterest
InterestPayments
Payments(an (anannuity)
annuity)
== Issue
IssuePrice
Priceof
ofthe
theBond
Bond

The interest rate used to compute the present

value is the market interest rate.
rate

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Measuring Bonds Payable and
Interest Expense
The stated rate is only used to compute
the periodic interest payments.

Interest
Interest == Principal
Principal ×× Stated
Stated Rate
Rate ×× Time
Time

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bond Premium and Discounts
Interest
Interest Bond
Bond Accounting
Accounting for
for
Rates
Rates Price
Price the
the Difference
Difference
Stated
Stated = Market
Market Bond
Bond = Par
ParValue
Value There
Thereisisno
nodifference
difference
Rate
Rate Rate
Rate Price
Price of
ofthe
theBond
Bond to
toaccount
accountfor.
for.
Stated
Stated < Market
Market Bond
Bond < Par
ParValue
Value The
Thedifference
differenceis
isaccounted
accounted
Rate
Rate Rate
Rate Price
Price of
ofthe
theBond
Bond for
foras
asaabond
bonddiscount.
discount.
Stated
Stated Market
Market Bond
Bond Par
ParValue
Value The
Thedifference
differenceis
isaccounted
accounted
Rate
Rate
> Rate
Rate Price
Price
> of
ofthe
theBond
Bond for
foras
asaabond
bondpremium.
premium.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

On
On May
May 1,
1, 2001,
2001, Harrah’s
Harrah’s issues
issues
$1,000,000
$1,000,000 inin bonds
bonds having
having aa stated
stated rate
rate
of
of 6%
6% annually.
annually. The
The bonds
bonds mature
mature in
in 10
10
years
years and
and interest
interest is
is paid
paid semiannually.
semiannually.
The
The market
market rate
rate is
is 8%
8% annually.
annually.
Are Harrah’s bonds issued at par,
at a discount, or at a premium?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

On
On May
May 1, 1, 2001,
2001, Harrah’s
Harrah’s issues
issues $1,000,000
$1,000,000
in
in bonds
bonds having
having aa stated
stated rate
rate of
of 6%
6%
annually.
annually. TheThe bonds
bonds mature
mature inin 10
10 years
years
and
and interest
interest is
is paid
paid semiannually.
semiannually. The The
market
market rate
rate is
is 8%
8% annually.
annually.

Interest
Interest Bond
Bond Accounting
Accounting for
for
Rates
Rates Price
Price the
the Difference
Difference
Stated
Stated Market
Market BBond
ond Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
RRate
ate
< RRate
ate Price
Price
< of
ofthe
theBBond
ond for
foras
asaabond
bonddiscount.
discount.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

On
On May
May 1, 1, 2001,
2001, Harrah’s
Harrah’s issues
issues $1,000,000
$1,000,000
in
in bonds
bonds having
having aa stated
stated rate
rate of
of 6%
6%
annually.
annually. TheThe bonds
bonds mature
mature inin 10
10 years
years
and
and interest
interest is
is paid
paid semiannually.
semiannually. The The
market
market rate
rate is
is 8%
8% annually.
annually.

Compute the issue price of

Harrah’s bonds.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

!Compute the present value of the

principal.
Present Value
Single Amount = Principal × Factor

Use
Use the
the present
present value
value ofof aa
single
single amount
amount table
table to
to find
find the
the
appropriate
appropriate factor.
factor.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

!Compute the present value of the

principal.
Present Value
Single Amount = Principal × Factor, i=4.0%

Use
Use thethe market
market rate
rate of
of 8%
8% toto
determine
determine present
present value.
value. Interest
Interest isis
paid
paid semiannually,
semiannually, so so the
the rate
rate is
is i=4%
i=4%
(8%
(8% ÷÷ 22 interest
interest periods
periods per
per year).
year).

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

!Compute the present value of the

principal.
Present Value
Single Amount = Principal × Factor, i=4.0% , n=20

Though
Though thethe maturity
maturity period
period is
is 10
10 years,
years,
there
there are
are 22 interest
interest periods
periods per
per year.
year. For
For
the
the present
present value
value computation,
computation, useuse n=20
n=20
(10
(10 years
years ×× 22 periods
periods per
per year).
year).

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

!Compute the present value of the

principal.
Present Value
Single Amount = Principal × Factor, i=4.0%, n=20
= $ 1,000,000 × 0.4564
= $ 456,400

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

"Compute the present value of the

interest payments.
Present Value
Annuity = Payment × Factor

The
The interest
interest payment
payment is
is computed
computed as:
as:
$1,000,000
$1,000,000 ×× 6%
6% ×× 6/12
6/12
== $30,000
$30,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

"Compute the present value of the

interest payments.
Present
PresentValue
Value
Annuity
Annuity == Payment
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 30,000
30,000

Use
Use the
the same
same i=4.0%
i=4.0% and
and n=20
n=20 used
used
for
for the
the present
present value
value of
of the
the principal,
principal,
but
but use
use the
the present
present value
value ofof an
an
annuity
annuity table.
table.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

"Compute the present value of the

interest payments.
Present
PresentValue
Value
Annuity
Annuity == Payment
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 30,000
30,000 ×× 13.5903
13.5903
== $$ 407,709
407,709

Now,
Now, the
the issue
issue price
price of
of the
the
bonds
bonds can
can bebe computed.
computed.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds

#Compute the issue price of the

bonds.

$$ 456,400
456,400 PPre
rese
sent
nt VVaalue
lue of
of the
the PPrincipa
rincipall
++ 407,709
407,709 PPre
rese
sent
nt VVaalue
lue of
of the
the Inte
Intere
rest
st
== $$ 864,109
864,109 PPre
rese
sent
nt VVaalue
lue of
of the
the Bonds
Bonds

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds

#Compute the issue price of the

bonds.

$$ 456,400
456,400 PPre
rese
The
sentThe
nt
$864,109
$864,109
VVaalue
lue of
of the
is
is less
lesslthan
the PPrincipa
rincipa lthan
++ 407,709
407,709 PPre se nt V athe
the
lue face
face
of theamount
re se nt V a lue of the Inte re st of
amount
Inte re st of
$1,000,000, so the bonds
== $$ 864,109
864,109 re se nt V a lue of the Bonds bonds
PPre se nt$1,000,000,
V a lue of the so the
Bonds
are
are issued
issued at
at aa discount
discount of
of
$135,891.
$135,891.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Recording Bonds
Issued at a Discount
$Prepare the journal entry to record
the issuance of the bonds.
GENERAL JOURNAL Page 97
Date Description Debit Credit
May 1 Cash 864,109
Discount on Bonds Payable 135,891
Bonds Payable 1,000,000
to record issuance of bonds
This
Thisisisaacontra-liability
contra-liabilityaccount
account and
andappears
appearsin
in
the
theliability
liabilitysection
sectionofofthe
thebalance
balancesheet.
sheet.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Bonds Issued at a Discount
Financial Statement Presentation

Harrah's
Partial Balance Sheet
At May 1, 2001
The discount
Long-Term Liabilities will be
Bonds Payable, 6% $ 1,000,000 amortized
Due April 30, 2011 over the 10-
Less: Bond Discount (135,891) year life of the
Total L-T Liabilities $ 864,109
bonds.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bonds Issued at a Discount
Financial Statement Presentation

Harrah's
Harrah's Two methods
Partial
PartialBalance
BalanceSheet
Sheet of amortization
At
AtMay
May1,
1,2001
2001 are commonly
used:
Long-Term
Long-TermLiabilities
Liabilities
Bonds
BondsPayable,
Payable,6% 6% $$ 1,000,000
1,000,000
Straight-line
Due
DueApril
April30,
30,2011
2011 or
Less:
Less:Bond
BondDiscount
Discount (135,891)
(135,891) Interest Method
Total
TotalL-T
L-TLiabilities
Liabilities $$ 864,109
864,109

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Straight-Line Amortization of
Bond Discount
!
!Identify
Identify the
the amount
amount of of the
the bond
bond
discount.
discount.
"
"Divide
Divide the
the bond
bond discount
discount by by the
the
number
number of of interest
interest periods.
periods.
#
#Include
Include the
the discount
discount amortization
amortization
amount
amount as as part
part of
of the
the periodic
periodic
interest
interest expense
expense entry.
entry.
The
The discount
discount willwill be
be reduced
reduced to to
zero
zero by
by the
the maturity
maturity date.
date.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Straight-Line Amortization of
Bond Discount
Harrah’s
Harrah’s issued
issued their
their bonds
bonds onon May
May 1,
1,
2001.
2001. The
The discount
discount was
was $135,891.
$135,891.
The
The bonds
bonds have
have aa 10-year
10-year maturity
maturity
and
and $30,000
$30,000 interest
interest is
is paid
paid
semiannually.
semiannually.
Compute
Compute the
the periodic
periodic discount
discount amortization
amortization
using
using the
the straight-line
straight-line method.
method.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Straight-Line Amortization of
Bond Discount
Harrah’s
Harrah’s issued
issued their
their bonds
bonds onon May
May 1,
1,
2001.
2001. The
The discount
discount was
was $135,891.
$135,891.
The
The bonds
bonds have
have aa 10-year
10-year maturity
maturity
and
and $30,000
$30,000 interest
interest is
is paid
paid
semiannually.
semiannually.
DDiscount
iscount Total
Total NNumber
umber of
of
Compute
Compute
Amortiz
the periodic
the periodic discount
discount amortization
amortization
Amortization
ation == DDiscount
using iscount ÷÷ Interest
InterestPeriods
Periods
using the
the straight-line
straight-line method.
method.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Straight-Line Amortization of
Bond Discount
Harrah’s
Harrah’s issued
issued their
their bonds
bonds onon May
May 1,
1,
2001.
2001. The
The discount
discount was
was $135,891.
$135,891.
The
The bonds
bonds have
have aa 10-year
10-year maturity
maturity
and
and $30,000
$30,000 interest
interest is
is paid
paid
semiannually.
semiannually.
DDiscount
iscount Total
Total NNumber
umber of
of
Compute
Compute
Amortiz
the periodic
the periodic discount
discount amortization
amortization
Amortization
ation == DDiscount
using iscount ÷÷ Interest
InterestPeriods
Periods
using the
the straight-line
straight-line method.
method.
== $$135,891
135,891 ÷÷ 20
20
== $$ 6,795
6,795 per
per period
period (rounded)
(rounded)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Straight-Line Amortization of
Bond Discount
Prepare
Prepare thethe journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the discount
discount amortization
amortization for
for
the
the six
six months
months ending
ending on
on November
November 1, 1, 2001.
2001.

GENERAL JOURNAL Page 123

Date Description Debit Credit
Nov. 1 Interest Expense 36,795
Discount on Bonds Payable 6,795
Cash 30,000
To record payment of interest

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bonds Issued at a Discount
Financial Statement Presentation

Harrah's
Harrah's As the
Partial
PartialBalance
BalanceSheet
Sheet discount is
At
AtNovember
November1, 1,2001
2001 amortized, the
carrying
Long-Term
Long-TermLiabilities
Liabilities
Bonds
amount of the
BondsPayable,
Payable,6% 6% $$ 1,000,000
1,000,000
Due
bonds
DueApril
April30,
30,2011
2011
Less:
Less:Bond
BondDiscount
Discount (129,096)
(129,096)
increases.
Total
TotalL-T
L-TLiabilities
Liabilities $$ 870,904
870,904

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Zero Coupon Bonds

• Zero coupon bonds do not pay

periodic interest.
• Because there is no interest
annuity . . .

PV
PV of
of the
the Principal
Principal == Issue
Issue Price
Price of
of the
the Bonds
Bonds

• This is called a deep discount

bond.
bond

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

Interest
Interest Bond
Bond Accounting
Accounting for
for
Rates
Rates Price
Price the
the Difference
Difference
Stated
Stated Market
Market BBond
ond Par Value There
Thereisisno
nodifference
RRate = RRate = ofPar Value difference
ate ate Price
Price the B ond
of the B ond to
toaccount
accountfor.
for.
Stated
Stated Market
Market BBond
ond Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
RRate < RRate <
ate ate Price
Price of
ofthe
theBBond
ond for
foras
asaabond
bonddiscount.
discount.
Stated
Stated Market
Market BBond
ond Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
RRate
ate
> RRate
ate Price
Price
> of
ofthe
theBBond
ond for
foras
asaabond
bondpremium.
premium.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

On
On May
May 1,
1, 2001,
2001, Harrah’s
Harrah’s issues
issues $1,000,000
$1,000,000 inin
bonds
bonds having
having aa stated
stated rate
rate of
of 10%
10% annually.
annually.
The
The bonds
bonds mature
mature inin 10
10 years
years and
and interest
interest is
is
paid
paid semiannually.
semiannually. The The market
market rate
rate is
is 8%
8%
annually.
annually.
Are Harrah’s bonds issued at par, at a
discount, or at a premium?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

On
On May
May 1,
1, 2001,
2001, Harrah’s
Harrah’s issues
issues $1,000,000
$1,000,000 inin
bonds
bonds having
having aa stated
stated rate
rate of
of 10%
10% annually.
annually.
The
The bonds
bonds mature
mature inin 10
10 years
years and
and interest
interest is
is
paid
paid semiannually.
semiannually. The The market
market rate
rate is
is 8%
8%
annually.
annually.
Interest
Interest Bond
Bond Accounting
Accounting for
for
Rates
Rates Price
Price the
the Difference
Difference
Stated
Stated Market
Market BBond
ond Par Value The
Thedifference
differenceisisaccounted
RRate > RRate > ofPar Value accounted
ate ate Price
Price the B ond
of the B ond for
foras
asaabond
bondpremium.
premium.

Let’s compute the issue price of the bonds.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds at a Premium

!Compute the present value of the

principal.
Present
PresentValue
Value
Single
Single Amount
Amount == Principal
Principal ×× Factor
Factor

Use
Use the
the present
present value
value ofof aa
single
single amount
amount table
table to
to find
find the
the
appropriate
appropriate factor.
factor.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

!Compute the present value of the

principal.
Present
PresentValue
Value
Single
Single Amount
Amount == Principal
Principal ×× Factor,
Factor, i=4.0%
i=4.0%

Use
Use the
the market
market rate
rate of
of 8%
8% toto determine
determine
present
present value.
value. Interest
Interest is is paid
paid
semiannually,
semiannually, so so the
the rate
rate is
is i=4.0%
i=4.0% (8%
(8%
÷÷ 22 interest
interest periods
periods perper year).
year).

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

!Compute the present value of the

principal.
Present
PresentValue
Value
Single
Single Amount
Amount == Principal
Principal ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20

The
The maturity
maturity period
period isis 10
10 years,
years, there
there
are
are 22 interest
interest periods
periods perper year.
year. For
For the
the
present
present value
value computation,
computation, use use n=20
n=20
(10
(10 years
years ×× 22 periods).
periods).

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

!Compute the present value of the

principal.
Present
PresentValue
Value
Single
Single Amount
Amount == Principal
Principal ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$1,000,000
1,000,000 ×× 0.4564
0.4564
== $$ 456,400
456,400

Next,
Next, we
we compute
compute thethe present
present
value
value of
of the
the interest
interest payments.
payments.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds at a Premium

"Compute the present value of the

interest payments.
Present
PresentValue
Value
Annuity
Annuity == Payment
Payment ×× Factor
Factor

The
The interest
interest payment
payment is
is computed
computed as:
as:
$1,000,000
$1,000,000 ×× 10%
10% ×× 6/12
6/12
== $50,000
$50,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Issuing Bonds at a Premium

"Compute the present value of the

interest payments.
Present
PresentValue
Value
Annuity
Annuity == Payment
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 50,000
50,000
Use
Use the
the same
same i=4.0%
i=4.0% and
and n=20
n=20 that
that
were
were used
used to
to compute
compute thethe present
present
value
value of
of the
the principal.
principal. Now,
Now,
however,
however, the
the factor
factor comes
comes from
from the
the
present
present value
value ofof an
an annuity
annuity table.
table.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds at a Premium

"Compute the present value of the

interest payments.
Present
PresentValue
Value
Annuity
Annuity == Payment
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 50,000
50,000 ×× 13.5903
13.5903
== $$ 679,515
679,515

Now,
Now, the
the issue
issue price
price of
of the
the
bonds
bonds can
can bebe computed.
computed.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds at a Premium

#Compute the issue price of the

bonds.

$$ 456,400
456,400 PPre
rese
sent
nt VVaalue
lue of
of the
the PPrincipa
rincipall
++ 679,515
679,515 PPre
rese
sent
nt VVaalue
lue of
of the
the Inte
Intere
rest
st
== $$1,135,915
1,135,915 PPre
rese
sent
nt VVaalue
lue of
of the
the Bonds
Bonds

The
The $1,135,915
$1,135,915 is
is greater
greater than
than the
the face
face amount
amount of
of
$1,000,000,
$1,000,000, so
so the
the bonds
bonds are
are issued
issued at at aa premium
premium of
of
$135,915.
$135,915.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Issuing Bonds at a Premium

$Prepare the journal entry to record

the issuance of the bonds.
GENERAL JOURNAL Page 97
Date Description Debit Credit
May 1 Cash 1,135,915
Bonds Payable 1,000,000
Premium on Bonds Payable 135,915

This
This is
is called
called an
an adjunct
adjunct account
account
and
and appears
appears inin the
the liability
liability section.
section.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Bonds Issued at a Premium
Financial Statement Presentation

Harrah's
Harrah's
Partial
PartialBalance
BalanceSheet
Sheet The
At
AtMay
May1,
1,2001
2001 premium
Long-Term
Long-TermLiabilities
Liabilities
will be
Bonds
BondsPayable,
Payable,10%10% $$ 1,000,000
1,000,000 amortized
Due
DueApril
April30,
30,2011
Add:
2011 over the 10-
Add:Bond
BondPremium
Premium 135,915
135,915
Total
TotalL-T
L-TLiabilities
Liabilities $$ 1,135,915
1,135,915 year life of
the bonds.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Effective-Interest Amortization of
Bond Discounts and Premiums
The effective-interest method
computes interest as:
Bond Carrying Value × Market Rate

Principal
Principal amount
amount of
of the
the bonds
bonds
less
less any
any unamortized
unamortized discount
discount or
or
plus
plus any
any unamortized
unamortized premium.
premium.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Effective-Interest Amortization of
Bond Discounts and Premiums
The effective-interest method
computes interest as:
Bond Carrying Value × Market Rate

This
This is
is the
the same
same market
market rate
rate
used
used to to determine
determine thethe
present
present value
value of
of the
the bond.
bond.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Effective-Interest Method
Recall
Recall our
our first
first example
example of of Harrah’s.
Harrah’s. OnOn May
May 1,
1, 2001,
2001,
the
the company
company issuesissues $1,000,000
$1,000,000 inin bonds
bonds having
having aa
stated
stated rate
rate of
of 6%
6%annually.
annually. TheThe bonds
bonds mature
mature in
in 10
10
years
years andand interest
interest is
is paid
paid semiannually.
semiannually. The
The
market
market rate
rate isis 8%
8% annually.
annually.
GENERAL JOURNAL Page 97
Date Description Debit Credit
May 1 Cash 864,109
Discount on Bonds Payable 135,891
Bonds Payable 1,000,000
to record issuance of bonds

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Effective-Interest Method

Principal amount of bonds $ 1,000,000

Less: unamortized discount (135,891)
Bond Carrying Value 864,109
Market interest rate 4.00%
Interest expense - 11/1/01 $ 34,564

The
Thecash
cashpaid
paidtotobond
bond Interest
Interestisispaid
paidsemi-
semi-
holders
holdersifif$30,000
$30,000 annually,
annually,sosothe
themarket
marketrate
rate
($1,000,000
($1,000,000××3%)3%) isis8%
8%÷÷22==4%.4%.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Effective-Interest Method
The journal entry to record the first
interest payment is:
GENERAL JOURNAL Page 123
Date Description Debit Credit
Nov. 1 Interest Expense 34,564
Discount on Bonds Payable 4,564
Cash 30,000
To record payment of interest

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Effective-Interest Method
The new bond carrying value of the
next interest payment period is:
Principal amount of bonds $ 1,000,000
Less: unamortized discount (131,327)
Bond Carrying Value 868,673

Unamortized discount $ 135,891

Less: amount amortized (4,564)
New unamortized discount 131,327

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Understanding Alternative
Amortization Methods
•• Effective-interest
Effective-interest method method of
of
amortization
amortization is is preferred
preferred byby
GAAP.
GAAP.
•• Straight-line
Straight-line amortization
amortization
may
may be
be used
used ifif itit is
is not
not
materially
materially different
different from from
effective
effective interest
interest
amortization.
amortization.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Early Retirement of Debt

•• Occasionally,
Occasionally, the the issuing
issuing
company
company willwill call
call (repay
(repay early)
early)
some
some oror all
all of
of its
its bonds.
bonds.
•• Gains/losses
Gains/losses incurred
incurred as as aa
result
result of
of retiring
retiring bonds,
bonds,
should
should be
be reported
reported as as an
an
extraordinary
extraordinary item item on
on the
the
income
income statement.
statement.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 End of Chapter 10

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001