Reporting and Interpreting Bonds
Chapter 10
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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
10-2
Equity - funds
from owners
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.
10-3
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.
Characteristics of Bonds Payable
Two types of cash payment in the bond contract:
1. Principal.
2. Cash interest payments.
Bond Terms
1. Principal, par value and face
value
2. Contract, stated, or coupon
rate of interest
3. Market, yield, or effectiveinterest rate
10-4
Characteristics of Bonds Payable
An indenture is a bond contract that
specifies the legal provisions of a
bond issue.

Debenture bonds
No assets are pledged as guarantee of repayment at maturity.

Secured bonds
Specific assets are pledged as guarantee of repayment at
maturity.

Callable bonds
Bond may be called for early retirement by the issuer.

Convertible bonds
Bond may be converted to other securities (usually common stock).
10-5
Characteristics of Bonds Payable
• The bond indenture contains
covenants designed to protect
the creditors.
• The bond issuer also prepares a
prospectus, which 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.
10-6
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
10-7
Bond
Price
Stated
Rate
=
Market Bond
Par Value
=
Rate Price
of the Bond
Stated
Rate
< Market Bond <
Stated
Rate
> Market Bond >
Rate
Rate
Price
Price
Accounting for
the Difference
There is no difference
to account for.
Par Value
of the Bond
The difference is accounted
for as a bond discount.
Par Value
of the Bond
The difference is accounted
for as a bond premium.
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.
10-8
Reporting Interest Expense:
Straight-line Amortization



10-9
Identify the amount of the
bond discount.
Divide the bond discount by
the number of interest
periods.
Include the discount
amortization amount as part
of the periodic interest
expense entry.
 The discount will be reduced
to zero by the maturity date.
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.
10-10
Zero Coupon Bonds

Zero coupon bonds do not pay
periodic interest.
Because there is no interest annuity, the
PV of the Principal = Issue Price of the Bonds

10-11
This is called a deep discount
bond.
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.
10-12
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
10-13
Focus on Cash Flows
Financing Activities –
 Issue of bonds (cash inflow)
 Retire debt (cash outflow)
 Repay bond principal at maturity (cash
outflow)
Remember that
payment of interest
under U.S. GAAP is
an operating activity.
10-14
End of Chapter 10
10-15