Chapter 10
Reporting and
Interpreting Bonds
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© 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
from creditors
Irwin/McGraw-Hill
Equity - funds
from owners
© The McGraw-Hill Companies, Inc., 2001
Business Background
Capital Structure - Bonds
Significant
Significant debt
debt needs
needs of
of aa
company
company are
are often
often filled
filled
by
by issuing
issuing bonds.
bonds.
Bonds
Irwin/McGraw-Hill
Cash
© The McGraw-Hill Companies, Inc., 2001
Business Background
Bonds
Bonds can
can be
be
traded
traded on
on
established
established
exchanges
exchanges that
that
provide
provide
liquidity
liquidity to
to
bondholders.
bondholders.
Irwin/McGraw-Hill
As liquidity
increases . . .
. . . Cost of
borrowing
decreases.
© 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 of
of 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 on
on bonds
bonds
allow
allow for
for positive
positive financial
financial
leverage.
leverage.
Irwin/McGraw-Hill
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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
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Key Ratio Analysis
The debt-equity ratio is an important
measure of the balance between debt and
equity.
Debt/equity
Debt/equity ratio
ratio ==
Total
Total liabilities
liabilities
Owners'
Owners' equity
equity
High debt-equity ratios indicate more
leverage and risk.
Irwin/McGraw-Hill
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Characteristics of Bonds Payable
At Bond Issuance Date
Company
Company
Issuing
Issuing
Bonds
Bonds
$ Bond Issue Price $
Bond Certificate
Investor
Investor
Buying
Buying
Bonds
Bonds
Bonds payable are long-term debt
for the issuing company.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Characteristics of Bonds Payable
$
Company
Company
Issuing
Issuing
Bonds
Bonds
$
Irwin/McGraw-Hill
Periodic
Interest Payments
$
Face Value
Payment at End of
Bond Term
$
Investor
Investor
Buying
Buying
Bonds
Bonds
© The McGraw-Hill Companies, Inc., 2001
Characteristics of Bonds Payable
Interest 10%
6/30 & 12/31
Face Value $1,000
BOND PAYABLE
Bond Date 1/1/01
1.
2.
3.
4.
5.
Maturity Date 1/1/10
Face Value = Maturity or Par Value, Principal
Maturity Date
Other Factors:
Stated Interest Rate
Interest Payment Dates 6. Market Interest Rate
7. Issue Date
Bond 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 are
are 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 sure
sure 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
Maybe
beturned
turnedin
inat
atany
anytime
timefor
forrepayment
repaymentat
atthe
theoption
optionof
of
the
thebondholder.
bondholder.
•• 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.
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 in
in the
the event
event of
of
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
Valueof
ofthe
thePrincipal
Principal (a
(asingle
singlepayment)
payment)
++ Present
PresentValue
Valueof
ofthe
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
Rates
Rates
Bond
Bond
Price
Price
Stated
Stated = Market
Market Bond
Bond = Par
ParValue
Value
Rate
Rate
of
Rate
Rate Price
Price
ofthe
theBond
Bond
Accounting
Accounting for
for
the
the Difference
Difference
There
Thereis
isno
nodifference
difference
to
toaccount
accountfor.
for.
Stated
Stated < Market
Market Bond
Bond < Par
ParValue
Value The
Thedifference
differenceis
isaccounted
accounted
for
Rate
Rate
of
foras
asaabond
bonddiscount.
discount.
Rate
Rate Price
Price
ofthe
theBond
Bond
Stated
Market
Par
Stated
Market Bond
Bond
ParValue
Value The
Thedifference
differenceis
isaccounted
accounted
>
>
for
Rate
Rate
of
foras
asaabond
bondpremium.
premium.
Rate
Rate Price
Price
ofthe
theBond
Bond
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. 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. 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.
Interest
Interest
Rates
Rates
Stated
Stated
RRate
ate
Irwin/McGraw-Hill
<
Market
Market BBond
ond
RRate
ate Price
Price
Bond
Bond
Price
Price
<
Accounting
Accounting for
for
the
the Difference
Difference
Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
of
for
ofthe
theBBond
ond
foras
asaabond
bonddiscount.
discount.
© 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. 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.
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 of
of 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 the
the market
market rate
rate of
of 8%
8% to
to
determine
determine present
present value.
value. Interest
Interest is
is
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 the
the 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, use
use 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 =
=
=
Irwin/McGraw-Hill
Principal
$ 1,000,000
$ 456,400
× Factor, i=4.0%, n=20
× 0.4564
© 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
==
Payment
Annuity
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 30,000
30,000
Use
Use the
the same
same i=4.0%
i=4.0% and
and n=20
n=20 used
used
for
for the
the present
present value
value of
of the
the principal,
principal,
but
but use
use the
the present
present value
value of
of an
an
annuity
annuity table.
table.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds
"Compute the present value of the
interest payments.
Present
PresentValue
Value
Annuity
==
Payment
Annuity
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 30,000
30,000 ×× 13.5903
13.5903
== $$ 407,709
407,709
Now,
Now, the
the issue
issue price
price of
of the
the
bonds
bonds can
can be
be computed.
computed.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds
#Compute the issue price of the
bonds.
++
==
$$ 456,400
456,400
407,709
407,709
$$ 864,109
864,109
Irwin/McGraw-Hill
PPre
rese
sent
nt VVaalue
lue of
of the
the PPrincipa
rincipall
PPre
rese
sent
nt VVaalue
lue of
of the
the Inte
Intere
rest
st
PPre
rese
sent
nt VVaalue
lue of
of the
the Bonds
Bonds
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds
#Compute the issue price of the
bonds.
++
==
$$ 456,400
456,400
407,709
407,709
$$ 864,109
864,109
Irwin/McGraw-Hill
The
$864,109
is
less
PPre
VVaalue
of
The
$864,109
is
lesslthan
rese
sent
nt
lue
of the
the PPrincipa
rincipa
lthan
the
face
amount
of
the
face
amount
PPre
se
nt
V
a
lue
of
the
Inte
re
st
re se nt V a lue of the Inte re st of
$1,000,000,
so
the
bonds
$1,000,000,
so
the
PPre
se
nt
V
a
lue
of
the
Bonds
re se nt V a lue of the Bonds bonds
are
are issued
issued at
at aa discount
discount of
of
$135,891.
$135,891.
© The McGraw-Hill Companies, Inc., 2001
Recording Bonds
Issued at a Discount
$Prepare the journal entry to record
the issuance of the bonds.
GENERAL JOURNAL
Date
Description
Page
Debit
97
Credit
May 1 Cash
864,109
Discount on Bonds Payable
135,891
Bonds Payable
1,000,000
to record issuance of bonds
This
Thisis
isaacontra-liability
contra-liabilityaccount
account and
andappears
appearsin
in
the
theliability
liabilitysection
sectionof
ofthe
thebalance
balancesheet.
sheet.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Bonds Issued at a Discount
Financial Statement Presentation
Harrah's
Partial Balance Sheet
At May 1, 2001
Long-Term Liabilities
Bonds Payable, 6%
Due April 30, 2011
Less: Bond Discount
Total L-T Liabilities
Irwin/McGraw-Hill
$ 1,000,000
$
(135,891)
864,109
The discount
will be
amortized
over the 10year life of the
bonds.
© The McGraw-Hill Companies, Inc., 2001
Bonds Issued at a Discount
Financial Statement Presentation
Harrah's
Harrah's
Partial
PartialBalance
BalanceSheet
Sheet
At
AtMay
May1,
1,2001
2001
Long-Term
Long-TermLiabilities
Liabilities
Bonds
BondsPayable,
Payable,6%
6%
Due
DueApril
April30,
30,2011
2011
Less:
Less:Bond
BondDiscount
Discount
Total
TotalL-T
L-TLiabilities
Liabilities
Irwin/McGraw-Hill
$$ 1,000,000
1,000,000
$$
(135,891)
(135,891)
864,109
864,109
Two methods
of amortization
are commonly
used:
Straight-line
or
Interest Method
© 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 will
will 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 on
on 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 on
on 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
Total
NNumber
of
iscount
Total
umber
of
Compute
the
periodic
discount
amortization
Compute
the periodic
discount
amortization
Amortiz
Amortization
ation == DDiscount
iscount ÷÷ Interest
InterestPeriods
Periods
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 on
on 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
Total
NNumber
of
iscount
Total
umber
of
Compute
the
periodic
discount
amortization
Compute
the periodic
discount
amortization
Amortiz
Amortization
ation == DDiscount
iscount ÷÷ Interest
InterestPeriods
Periods
using
using the
the straight-line
straight-line method.
method.
== $$135,891
135,891 ÷÷ 20
20
== $$
Irwin/McGraw-Hill
6,795
6,795 per
per period
period (rounded)
(rounded)
© The McGraw-Hill Companies, Inc., 2001
Straight-Line Amortization of
Bond Discount
Prepare
Prepare the
the journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the discount
discount amortization
amortization for
for
the
the six
six months
months ending
ending on
on November
November 1,
1, 2001.
2001.
GENERAL JOURNAL
Date
Description
Nov. 1 Interest Expense
Discount on Bonds Payable
Cash
To record payment of interest
Irwin/McGraw-Hill
Page
Debit
123
Credit
36,795
6,795
30,000
© The McGraw-Hill Companies, Inc., 2001
Bonds Issued at a Discount
Financial Statement Presentation
Harrah's
Harrah's
Partial
PartialBalance
BalanceSheet
Sheet
At
AtNovember
November1,
1,2001
2001
Long-Term
Long-TermLiabilities
Liabilities
Bonds
BondsPayable,
Payable,6%
6%
Due
DueApril
April30,
30,2011
2011
Less:
Less:Bond
BondDiscount
Discount
Total
TotalL-T
L-TLiabilities
Liabilities
Irwin/McGraw-Hill
$$ 1,000,000
1,000,000
$$
(129,096)
(129,096)
870,904
870,904
As the
discount is
amortized, the
carrying
amount of the
bonds
increases.
© 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
Rates
Rates
Stated
Stated
RRate
ate
Stated
Stated
RRate
ate
Stated
Stated
RRate
ate
=
Market
Market BBond
ond
RRate
ate Price
Price
<
Market
Market BBond
ond
RRate
ate Price
Price
>
Market
Market BBond
ond
RRate
ate Price
Price
Irwin/McGraw-Hill
Bond
Bond
Price
Price
Par Value
Value
= ofPar
the B ond
of the B ond
Accounting
Accounting for
for
the
the Difference
Difference
There
Thereisisno
nodifference
difference
to
toaccount
accountfor.
for.
<
Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
of
for
ofthe
theBBond
ond
foras
asaabond
bonddiscount.
discount.
>
Par
ParValue
Value The
Thedifference
differenceisisaccounted
accounted
of
for
ofthe
theBBond
ond
foras
asaabond
bondpremium.
premium.
© 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 in
in
bonds
bonds having
having aa stated
stated rate
rate of
of 10%
10% 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 at a Premium
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 10%
10% 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.
Interest
Interest
Rates
Rates
Stated
Stated
RRate
ate
>
Market
Market BBond
ond
RRate
ate Price
Price
Bond
Bond
Price
Price
Accounting
Accounting for
for
the
the Difference
Difference
Par Value
The
Thedifference
differenceisisaccounted
accounted
for
of the B ond
foras
asaabond
bondpremium.
premium.
Value
> ofPar
the B ond
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 of
of 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% to
to 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 per
per 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 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, 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
$$ 456,400
456,400
Next,
Next, we
we compute
compute the
the present
present
value
value of
of the
the interest
interest payments.
payments.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds at a Premium
"Compute the present value of the
interest payments.
Present
PresentValue
Value
Annuity
==
Annuity
Payment
Payment
×× Factor
Factor
The
The interest
interest payment
payment is
is computed
computed as:
as:
$1,000,000
$1,000,000 ×× 10%
10% ×× 6/12
6/12
== $50,000
$50,000
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds at a Premium
"Compute the present value of the
interest payments.
Present
PresentValue
Value
Annuity
==
Payment
Annuity
Payment ×× Factor,
Factor, i=4.0%
i=4.0%,, n=20
n=20
== $$ 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 the
the 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 of
of 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
==
Payment
Annuity
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 be
be computed.
computed.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Issuing Bonds at a Premium
#Compute the issue price of the
bonds.
++
==
$$ 456,400
456,400
679,515
679,515
$$1,135,915
1,135,915
PPre
rese
sent
nt VVaalue
lue of
of the
the PPrincipa
rincipall
PPre
rese
sent
nt VVaalue
lue of
of the
the Inte
Intere
rest
st
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
Date
May
Description
1 Cash
Bonds Payable
Premium on Bonds Payable
Page
Debit
97
Credit
1,135,915
1,000,000
135,915
This
This is
is called
called an
an adjunct
adjunct account
account
and
and appears
appears in
in 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
At
AtMay
May1,
1,2001
2001
Long-Term
Long-TermLiabilities
Liabilities
Bonds
BondsPayable,
Payable,10%
10%
Due
DueApril
April30,
30,2011
2011
Add:
Add:Bond
BondPremium
Premium
Total
TotalL-T
L-TLiabilities
Liabilities
Irwin/McGraw-Hill
$$ 1,000,000
1,000,000
135,915
135,915
$$ 1,135,915
1,135,915
The
premium
will be
amortized
over the 10year life of
the bonds.
© 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 the
the
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. On
On May
May 1,
1, 2001,
2001,
the
the company
company 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. 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.
GENERAL JOURNAL
Date
May
Irwin/McGraw-Hill
Description
1 Cash
Discount on Bonds Payable
Bonds Payable
to record issuance of bonds
Page
Debit
97
Credit
864,109
135,891
1,000,000
© The McGraw-Hill Companies, Inc., 2001
Effective-Interest Method
Principal amount of bonds
Less: unamortized discount
Bond Carrying Value
Market interest rate
Interest expense - 11/1/01
The
Thecash
cashpaid
paidto
tobond
bond
holders
holdersifif$30,000
$30,000
($1,000,000
($1,000,000××3%)
3%)
Irwin/McGraw-Hill
$
$
1,000,000
(135,891)
864,109
4.00%
34,564
Interest
Interestisispaid
paidsemisemiannually,
annually,so
sothe
themarket
marketrate
rate
isis8%
8%÷÷22==4%.
4%.
© The McGraw-Hill Companies, Inc., 2001
Effective-Interest Method
The journal entry to record the first
interest payment is:
GENERAL JOURNAL
Date
Description
Nov. 1 Interest Expense
Discount on Bonds Payable
Cash
To record payment of interest
Irwin/McGraw-Hill
Page
Debit
123
Credit
34,564
4,564
30,000
© 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
Less: unamortized discount
Bond Carrying Value
Unamortized discount
Less: amount amortized
New unamortized discount
Irwin/McGraw-Hill
$
$
1,000,000
(131,327)
868,673
135,891
(4,564)
131,327
© The McGraw-Hill Companies, Inc., 2001
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2001
Early Retirement of Debt
•• 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,
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