Professional Documents
Culture Documents
Chap 010
Chap 010
10-2
Debt - funds
from creditors
McGraw-Hill/Irwin
Equity - funds
from owners
10-3
McGraw-Hill/Irwin
Cash
10-4
Bonds
A bond is a DEBT SECURITY that corporations, credit
institutions or governmental bodies issue when they
borrow large amounts of money.
It is a formal contract to repay borrowed money with
interest at fixed intervals.
Bonds provide the borrower with external funds to
finance long-term investments or, in the case of
government bonds, to finance current expenditure.
McGraw-Hill/Irwin
10-5
Bonds
Bonds are
are debt,
debt,
not
not equity,
equity,so
so
the
the ownership
ownership
and
and control
control of
of
the
the company
company
are
are not
not diluted.
diluted.
Interest
Interest
expense
expense is
is taxtaxdeductible.
deductible.
McGraw-Hill/Irwin
Disadvantages
Disadvantages of
of bonds:
bonds:
Risk
Risk of
of bankruptcy;
bankruptcy; the
the
debt
debt must
must be
be paid
paid back
back
regularly,
regularly,or
or creditors
creditors
will
will force
force legal
legal action.
action.
Negative
Negative impact
impact on
on
cash
cash flows.
flows.
10-6
Characteristics of Bonds
At Bond Issuance Date
Company
Company
Issuing
Issuing
Bonds
Bonds
Bond Certificate
Investor
Investor
Buying
Buying
Bonds
Bonds
10-7
Characteristics of Bonds
$
Company
Company
Issuing
Issuing
Bonds
Bonds
McGraw-Hill/Irwin
Periodic
Interest Payments
(coupon)
Face (par) Value
Payment at End of
Bond Term
$
Investor
Investor
Buying
Buying
Bonds
Bonds
10-8
Bond Indenture
Bond
McGraw-Hill/Irwin
10-9
Bond Indenture
Face Value $1,000
Interest 10%
6/30 & 12/31
BOND
Bond Date 1/1/01
1.
2.
3.
4.
5.
McGraw-Hill/Irwin
10-10
Characteristics of Bonds
When
When issuing
issuing bonds,
bonds, potential
potential
buyers
buyers of
of the
the bonds
bonds are
are given
given aa
prospectus.
prospectus.
The
The companys
companys bonds
bonds are
are
issued
issued to
to investors
investors through
through an
an
underwriter
underwriter (buys
(buys an
an entire
entire
issue
issue of
of bonds
bonds and
and re-sells
re-sells
them
them to
to investors).
investors).
The
The trustee
trustee makes
makes sure
sure the
the
issuer
issuer fulfills
fulfills all
all of
of the
the
provisions
provisions of
of the
the bond
bond
indenture.
indenture.
McGraw-Hill/Irwin
10-11
Bond Classifications
Secured
Securedbonds
bonds
Secured
Securedwith
withthe
thepledge
pledgeof
ofaaspecific
specificasset.
asset.
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
timeprior
priorto
tothe
the
maturity
maturitydate
dateat
atthe
theoption
optionof
ofthe
theissuer.
issuer.
ItIthappens
happenswhen
whenthe
theissuer
issuerisispaying
payingaatoo
toohigh
highcoupon
couponrate
rate
than
the
current
market
interest
than the current market interest
They
Theymay
maybe
bereissued
reissuedat
ataalower
lowerinterest
interest
Called
Calledprotection
protectioncovenant:
covenant:states
statesthe
theperiod
periodin
inwhich
whichthe
the
bond
cannot
be
called
bond cannot be called
McGraw-Hill/Irwin
10-12
Bond Classifications
Term
Termbonds
bonds
The
Theprincipal
principalisispayable
payablein
infull
fullat
ataasingle
singlespecific
specificdate
datein
inthe
the
future
future
Serial
Serialbonds
bonds
The
Theprincipal
principalis
ispayable
payablein
ininstallments
installmentson
onaaseries
series
of
ofspecific
specificmaturity
maturitydates
dates
Convertible
Convertiblebonds
bonds
May
Maybe
beexchanged
exchangedfor
forother
othersecurities
securitiesof
ofthe
theissuer
issuer
(usually
(usuallyshares
sharesof
ofcommon
commonstock)
stock)at
atthe
theoption
optionof
ofthe
the
bondholder.
bondholder.
McGraw-Hill/Irwin
10-13
10-14
McGraw-Hill/Irwin
10-15
McGraw-Hill/Irwin
10-16
McGraw-Hill/Irwin
10-17
<
<
>
>
McGraw-Hill/Irwin
10-18
10-19
<
McGraw-Hill/Irwin
<
10-20
McGraw-Hill/Irwin
10-21
McGraw-Hill/Irwin
10-22
Use
Usethe
themarket
marketrate
rateof
of12%
12%to
todetermine
determinepresent
present
value.
value. Interest
Interestis
ispaid
paidsemiannually,
semiannually,so
sothe
therate
rateis
is
rr==6%
6%(12%
(12%22interest
interestperiods
periodsper
peryear).
year).
Though
Thoughthe
thematurity
maturityperiod
periodis
is10
10years,
years,there
thereare
are22interest
interest
periods
periodsper
peryear.
year. For
Forthe
thepresent
presentvalue
valuecomputation,
computation,use
use
n=20
n=20(10
(10years
years22periods
periodsper
peryear).
year).
McGraw-Hill/Irwin
10-23
1
PV C
T
r r (1 r )
McGraw-Hill/Irwin
10-24
McGraw-Hill/Irwin
10-25
1
1
PV 5,000
20
0.06 0.06(1 0.06)
57,350$
Use
Use the
the same
same rr == 6.0%
6.0%and
and n=20
n=20 used
used
for
for the
the present
present value
value of
of the
the principal.
principal.
McGraw-Hill/Irwin
10-26
$$
++
== $$
McGraw-Hill/Irwin
31,180
31,180
57,350
57,350
88,530
88,530
Present
Present Value
Value of
of the
the Principal
Principal
Present
Present Value
Value of
of the
the Interest
Interest
Present
Present Value
Value of
of the
the Bonds
Bonds
10-27
$$
31,180
31,180
57,350
57,350
88,530
88,530
++
== $$
The
$88,530
is
$88,530
is less
less than
than
Present
Value
of
PresentThe
Value
of the
the Principal
Principal
the
face
amount
of
the
face
amount
Present
Value
of
the
Interest
Present Value of the Interest of
$100,000,
soBonds
the bonds
Present
Present Value
Value of
of the
the Bonds
10-28
Recording Bonds
Issued at a Discount
4.
4. Prepare
Prepare the
the journal
journal entry
entry to
to record
record the
the
issuance
issuance of
of the
the bonds.
bonds.
This
Thisis
isaa contra-liability
contra-liabilityaccount
account and
and appears
appearsin
in
the
theliability
liabilitysection
sectionof
ofthe
thebalance
balancesheet.
sheet.
McGraw-Hill/Irwin
10-29
The discount
will be
amortized
over the 10year life of the
bonds.
McGraw-Hill/Irwin
10-30
10-31
10-32
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 will
will be
be reduced
reduced
to
to zero
zero by
bythe
the maturity
maturitydate.
date.
McGraw-Hill/Irwin
10-33
Straight-Line Amortization of
Bond Discount
Harrahs
Harrahs issued
issued their
their bonds
bonds on
on Jan.
Jan. 1,
1, 2003.
2003. The
The
discount
discount was
was $11,470.
$11,470. The
The bonds
bonds have
have aa 10-year
10-year
maturity
maturity and
and $5,000
$5,000 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.
McGraw-Hill/Irwin
10-34
Straight-Line Amortization of
Bond Discount
Harrahs
Harrahs issued
issued their
their bonds
bonds on
on Jan.
Jan. 1,
1, 2003.
2003. The
The
discount
discount was
was $11,470.
$11,470. The
The bonds
bonds have
have aa 10-year
10-year
maturity
maturity and
and $5,000
$5,000 interest
interest is
is paid
paid semiannually.
semiannually.
Compute
Compute the
the periodic
periodic discount
discount amortization
amortization
using
using the
the straight-line
straight-line method.
method.
McGraw-Hill/Irwin
10-35
Straight-Line Amortization of
Bond Discount
Prepare
Prepare the
the journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the discount
discount amortization
amortization for
for
the
the six
six months
months ending
ending on
on June
June 30,
30, 2003.
2003.
McGraw-Hill/Irwin
10-36
McGraw-Hill/Irwin
10-37
10-38
McGraw-Hill/Irwin
10-39
McGraw-Hill/Irwin
10-40
<
<
>
>
McGraw-Hill/Irwin
10-41
Are
Are Harrahs
Harrahs bonds
bonds issued
issued at
at
par,
par, at
at aa discount,
discount, or
or at
at aa
premium?
premium?
McGraw-Hill/Irwin
10-42
>
>
10-43
Use
Usethe
themarket
marketrate
rateof
of8%
8%to
todetermine
determinepresent
presentvalue.
value.
Interest
Interestis
ispaid
paidsemiannually,
semiannually,so
sothe
therate
rateis
isrr==4.0%
4.0%(8%
(8%
22interest
interestperiods
periodsper
peryear).
year).
The
Thematurity
maturityperiod
periodis
is10
10years,
years,there
thereare
are22interest
interest
periods
periodsper
peryear.
year. For
Forthe
thepresent
presentvalue
valuecomputation,
computation,
use
usen=20
n=20(10
(10years
years22periods).
periods).
McGraw-Hill/Irwin
10-44
McGraw-Hill/Irwin
10-45
1
1
PV 5,000
20
0
.
04
0
.
04
(
1
0
.
04
)
67,952$
Use
Usethe
thesame
samer=4.0%
r=4.0%and
and n=20
n=20that
that were
were
used
usedto
tocompute
computethe
thepresent
present value
valueof
ofthe
the
principal.
principal.
McGraw-Hill/Irwin
10-46
The
The $113,592
$113,592 is
is greater
greater than
than the
the face
face amount
amount of
of
$100,000,
$100,000, so
so the
the bonds
bonds are
are issued
issued at
at aa premium
premium
of
of $13,592.
$13,592.
McGraw-Hill/Irwin
10-47
This
This is
is called
called an
an adjunct
adjunct account
account
and
and appears
appears in
in the
the liability
liability section.
section.
McGraw-Hill/Irwin
10-48
10-49
Straight-Line Amortization of
Bond Premium
Identify
Identify the
the amount
amount of
of the
the
bond
bond premium.
premium.
Divide
Divide the
the bond
bond premium
premium by
by
the
the number
number of
of interest
interest
periods.
periods.
The
The premium
premium amortization
amortization
amount
amount is
is subtracted
subtracted from
from the
the
interest
interest payment
payment to
to calculate
calculate
interest
interest expense.
expense.
McGraw-Hill/Irwin
10-50
Straight-Line Amortization of
Bond Premium
Harrahs
Harrahs issued
issued their
their bonds
bonds on
on Jan.
Jan. 1,
1, 2003.
2003. The
The
premium
premium was
was $13,592.
$13,592. The
The bonds
bonds have
have aa 10-year
10-year
maturity
maturity and
and $5,000
$5,000 interest
interest is
is paid
paid semiannually.
semiannually.
Compute
Compute the
the periodic
periodic premium
premium amortization
amortization
using
using the
the straight-line
straight-line method.
method.
McGraw-Hill/Irwin
10-51
Straight-Line Amortization of
Bond Premium
Prepare
Prepare the
the journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the premium
premium amortization
amortization for
for
the
the six
six months
months ending
ending on
on June
June 30,
30, 2003.
2003.
McGraw-Hill/Irwin
10-52
McGraw-Hill/Irwin
10-53
McGraw-Hill/Irwin
10-54
Effective-Interest Amortization of
Bond Discounts and Premiums
The effective-interest method
computes interest as:
10-55
Effective-Interest Amortization of
Bond Discounts and Premiums
The effective-interest method
computes interest as:
10-56
Effective-Interest Method of a
bond discount
Recall
Recall our
ourfirst
firstexample
exampleof
ofHarrahs.
Harrahs. On
OnJan.
Jan. 1,
1,2003,
2003,the
the
company
companyissues
issues$100,000
$100,000in
inbonds
bondshaving
havingaastated
statedrate
rate
of
of 10%
10%annually.
annually. The
Thebonds
bondsmature
maturein
in10
10years
yearsand
and
interest
interest is
ispaid
paidsemiannually.
semiannually. The
Themarket
market rate
rateis
is 12%
12%
annually.
annually.
McGraw-Hill/Irwin
10-57
Effective-Interest Method of a
bond discount
The
Thecash
cashpaid
paidto
tobond
bond
holders
holdersfor
forinterest
interestis
is
$5,000
$5,000($100,000
($100,000 10%
10%
6/12
6/12))
McGraw-Hill/Irwin
Interest
Interestis
ispaid
paidsemisemiannually,
annually,so
so the
themarket
market
rate
rate is
is12%
12%22== 6%.
6%.
10-58
Effective-Interest Method of a
bond discount
The journal entry to record the first
interest payment is:
The amount of the discount that has been amortized is the difference
between the interest expense and the cash paid.
McGraw-Hill/Irwin
10-59
Effective-Interest Method of a
bond discount
McGraw-Hill/Irwin
10-60
10-61
McGraw-Hill/Irwin
10-62
McGraw-Hill/Irwin
10-63
Effective-Interest Method of a
bond premium
Recall
Recall our
oursecond
secondexample
exampleof
ofHarrahs.
Harrahs. On
OnJan.
Jan.1,
1,2003,
2003,
the
thecompany
companyissues
issues$100,000
$100,000 in
inbonds
bondshaving
havingaa stated
stated
rate
rateof
of 10%
10%annually.
annually. The
Thebonds
bondsmature
maturein
in10
10years
yearsand
and
interest
interestis
ispaid
paidsemiannually.
semiannually. The
Themarket
marketrate
rateis
is8%
8%
annually.
annually.
McGraw-Hill/Irwin
10-64
Effective-Interest Method of a
bond premium
The
Thecash
cashpaid
paidto
tobond
bond
holders
holdersfor
forinterest
interestis
is
$5,000
$5,000($100,000
($100,000 10%
10%
6/12
6/12))
McGraw-Hill/Irwin
Interest
Interestis
ispaid
paidsemisemiannually,
annually,so
so the
themarket
market
rate
rateis
is8%
8%22 ==4%.
4%.
10-65
Effective-Interest Method of a
bond premium
The journal entry to record the first
interest payment is:
The amount of the premium that has been amortized is the difference
between the cash paid and the interest expense.
McGraw-Hill/Irwin
10-66
Effective-Interest Method of a
bond premium
McGraw-Hill/Irwin
10-67
McGraw-Hill/Irwin
10-68
McGraw-Hill/Irwin
10-69
Understanding Alternative
Amortization Methods
Effective-interest
Effective-interest method
method of
of
amortization
amortization is
is preferred
preferred by
by
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.
McGraw-Hill/Irwin
10-70
Understanding Alternative
Amortization Methods
Straight-line amortization
The discount or premium is amortized in equal
10-71
Occasionally,
Occasionally,the
the issuing
issuing
company
company will
will call
call (repay
(repay
early)
early) some
some or
or 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 (book
(book
value
value of
of debt-market
debt-market value
value of
of
debt)
debt) should
should be
be reported
reported as
as
an
an extraordinary
extraordinary item
item on
on the
the
income
income statement.
statement.
McGraw-Hill/Irwin
10-72
McGraw-Hill/Irwin
10-73
cash outflow)
McGraw-Hill/Irwin
10-74
End of Chapter 10
McGraw-Hill/Irwin