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Chapter 10

Reporting and Interpreting


Bonds

10-2

Understanding the Business


The mixture of debt and equity used to
finance a companys operations is
called the capital structure:

Debt - funds
from creditors
McGraw-Hill/Irwin

Equity - funds
from owners

2004 The McGraw-Hill Companie

10-3

Understanding the Business:


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

McGraw-Hill/Irwin

Cash

2004 The McGraw-Hill Companie

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.

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10-5

Pro and cons of bonds


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 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.

2004 The McGraw-Hill Companie

10-6

Characteristics of Bonds
At Bond Issuance Date
Company
Company
Issuing
Issuing
Bonds
Bonds

$ Bond Issue Price $

Bond Certificate

Investor
Investor
Buying
Buying
Bonds
Bonds

Bonds are long-term debt for the


issuing company.
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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

2004 The McGraw-Hill Companie

10-8

Bond Indenture
Bond

indenture is a bond contract that


specifies the legal provisions of bonds
(maturity date, interest rate, date of
interest payments, conversion
privileges..)
It can also contain covenants to
protect creditors

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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.

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

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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

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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

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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.

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10-13

Key Ratio Analysis


The debt-equity ratio is an important
measure of the balance between debt
and equity.

High debt-equity ratios indicate more


leverage and risk.
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10-14

Measuring Bonds Payable and


Interest Expense
The stated rate is only used to compute
the periodic interest payments.

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10-15

Issue price of a bond


The issue price of the bond is determined
by the market, based on the time value of
money.

The interest rate used to compute the


present value is the market interest rate
(yield).
(yield)

McGraw-Hill/Irwin

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10-16

Issue price of a bond


The present value of a bond may be:
the same as par
above the par (BOND PREMIUM)
below the par (BOND DISCOUNT)
The bond sells at par

Stated rate=market rate

The bond sells at premium Stated rate>market rate


The bond sells at discount Market rate>stated rate

McGraw-Hill/Irwin

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10-17

Bond Premium and Discounts

<

<

>

>

McGraw-Hill/Irwin

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10-18

Computing Bond Prices


On
On January
January 1,
1, 2003,
2003, Harrahs
Harrahs issues
issues $100,000
$100,000
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 12%
12%annually.
annually.

Are Harrahs bonds issued at


par, at a discount, or at a
premium?
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-19

Computing Bond Prices


On
On January
January 1,
1, 2003,
2003, Harrahs
Harrahs issues
issues $100,000
$100,000
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 12%
12%annually.
annually.

<
McGraw-Hill/Irwin

<

2004 The McGraw-Hill Companie

10-20

Computing Bond Prices


On
On January
January 1,
1, 2003,
2003, Harrahs
Harrahs issues
issues $100,000
$100,000
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 12%
12%annually.
annually.

Compute the issue price of


Harrahs bonds.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-21

Computing Bond Prices


1. Compute the present value of the
principal.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-22

Computing Bond Prices


1. Compute the present value of the
principal.
PV=100,000/(1+0.06)20=31,180

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

2004 The McGraw-Hill Companie

10-23

Computing Bond Prices


2. Compute the present value of interest
payments

1
PV C
T
r r (1 r )

McGraw-Hill/Irwin

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10-24

Computing Bond Prices


2. Compute the present value of interest
payments
The
The semi-annual
semi-annual interest
interest payment
payment is
is
computed
computed as:
as:
$100,000
$100,000 10%
10% 6/12
6/12
== $5,000
$5,000

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-25

Computing Bond Prices


2. Compute the present value of interest
payments

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

2004 The McGraw-Hill Companie

10-26

Computing Bond Prices


3.
3. Compute
Compute the
the issue
issue price
price of
of the
the bonds.
bonds.

$$

++
== $$

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

2004 The McGraw-Hill Companie

10-27

Computing Bond Prices


3.
3. Compute
Compute the
the issue
issue price
price of
of the
the bonds.
bonds.

$$

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, so the bonds


are
are issued
issued at
at aa discount
discount of
of
$11,470.
$11,470.

$100,000,
soBonds
the bonds
Present
Present Value
Value of
of the
the Bonds

BONDS are sold at 88.5% of their par


value!!
McGraw-Hill/Irwin

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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

2004 The McGraw-Hill Companie

10-29

Bonds Issued at a Discount


Financial Statement Presentation

The discount
will be
amortized
over the 10year life of the
bonds.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-30

Bonds Issued at a Discount


The issuer must pay 100,000$ when the bond
matures, but received only 88,530$ when the
bond was issued!
The extra cash that must be paid to
bondholders is put as an adjustment to the
interest expense.
To adjust the interest expense, the issuer
amortizes the bond discount to each interest
period as an increase in interest expense.
McGraw-Hill/Irwin

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10-31

Bonds Issued at a Discount


Financial Statement Presentation
Two methods
of amortization
are commonly
used:
Straight-line
or
Effective
Interest Method
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

10-36

Bonds Issued at a Discount


Financial Statement Presentation
As the
discount is
amortized, the
carrying
amount of the
bonds
increases.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-37

Bonds Issued at a Discount


In each interest period, the book value of
the bonds increases by 574$ because the
unamortized bond discount decreases by
574$.
At maturity date, the unamortized bond
discount is zero.
At maturity date, the maturity amount of
bonds and the book value are the same:
100,000$
McGraw-Hill/Irwin

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10-38

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 because it sells for less
than its maturity value.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-39

Zero Coupon Bonds


Zero

coupon bonds issued for


100,000$ for 10 years, the
market rate is 10%. The issue
price will be:
PV=100,000/(1+0.10)10=38,554$

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-40

Issuing Bonds at a Premium

<

<

>

>

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-41

Issuing Bonds at a Premium


On
On January
January 1,
1, 2003,
2003, Harrahs
Harrahsissues
issues $100,000
$100,000 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
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

2004 The McGraw-Hill Companie

10-42

Issuing Bonds at a Premium


On
On January
January 1,
1, 2003,
2003, Harrahs
Harrahsissues
issues $100,000
$100,000 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.

>

>

Lets compute the issue price of the bonds.


McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-43

Computing Bond Prices


1. Compute the present value of the
principal.
PV=100,000/(1+0.04)20=45,640$

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

2004 The McGraw-Hill Companie

10-44

Computing Bond Prices


2. Compute the present value of interest
payments
The
The semiannual
semiannual interest
interest payment
payment is
is
computed
computed as:
as:
$100,000
$100,000 10%
10% 6/12
6/12
== $5,000
$5,000

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-45

Computing Bond Prices


2. Compute the present value of interest
payments

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

2004 The McGraw-Hill Companie

10-46

Issuing Bonds at a Premium


3.
3. Compute
Compute the
the present
present value
value of
of the
the
interest
interest payments.
payments.

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

2004 The McGraw-Hill Companie

10-47

Issuing Bonds at a Premium


4.
4. Prepare
Prepare the
the journal
journal entry
entry to
to record
record the
the
issuance
issuance of
of the
the bonds
bonds at
at aa premium.
premium.

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

2004 The McGraw-Hill Companie

10-48

Bonds Issued at a Premium


Financial Statement Presentation
The
premium will
be amortized
over the 10year life of
the bonds to
each interest
period.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

10-52

Bonds Issued at Premium


Financial Statement Presentation
As the
premium is
amortized, the
carrying
amount of the
bonds
decreases.

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2004 The McGraw-Hill Companie

10-53

Bonds Issued at Premium


At maturity date, the bond premium is
fully amortized.
At maturity date, the maturity amount of
bonds and the book value are the same:
100,000$

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-54

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.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-55

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.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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%.

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

10-59

Effective-Interest Method of a
bond discount

The new bond carrying value of the next


interest payment period is:

The amortization of the


bond discount
increases the bond
book value!

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-60

Understanding the amortization


of a bond discount
The amortization of a bond discount can
be thought of as interest earned by bond
holders but not paid to them.
During the first 6 months of 2003, the
bond holders earned an interest of
5,312$ but received only 5,000$.
The additional 312$ was added to the
principal and will be paid to bond holders
when the bond matures!
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-61

Understanding the amortization


of a bond discount
In the second 6 months of 2003:
Interest expense=88,842$*0.06=5,330$
5,330-5,000=330$ (amortized discount)

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-62

Understanding the amortization


of a bond discount

The new bond carrying value of the next


interest payment period is:

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

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%.

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

10-66

Effective-Interest Method of a
bond premium

The new bond carrying value of the next


interest payment period is:

The amortization of the


bond premium
decreases the bond
book value!

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-67

Understanding the amortization


of a bond premium
In the second 6 months of 2003:
Interest expense=113,136$*0.04=4,525$
5,000-4,525=475$ (amortized premium)

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-68

Understanding the amortization


of a bond premium

The new bond carrying value of the next


interest payment period is:

The amortization of the


bond premium
decreases the bond
book value!

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

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

2004 The McGraw-Hill Companie

10-70

Understanding Alternative
Amortization Methods

Straight-line amortization
The discount or premium is amortized in equal

amounts each period.

Effective interest amortization


The discount or premium is amortized over the

life of the debt.


The interest expense is equal to the market
interest rate (at the time of issuance) multiplied
by the amount of debt outstanding at the
beginning of the given period.
The difference between the interest expense
and the cash paid (for interest payments)
represents the amortization of the discount or
premium.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-71

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 (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

2004 The McGraw-Hill Companie

10-72

Early Retirement of Debt

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-73

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)

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie

10-74

End of Chapter 10

McGraw-Hill/Irwin

2004 The McGraw-Hill Companie