Ch. 10: Reporting and Interpreting Bonds
I. What are bonds?
A. Long-Term debt sold to creditors. (A long-term liability)
A bond makes (2) promises:
1. Repayment of principal at maturity (face value of bond)
2. Periodic interest payments: annual, semi-annual
Ex: $200,000 face value, 3 year bonds. Interest paid semi-annually,
Coupon rate =10% APR
B. Bond Terminology
1. Face Value (Par Value) – The denomination of the bond. Amount due
at maturity.
1. Coupon (Stated, Face) Interest Rate - fixed rate of interest that will
be paid each interest payment. Set by Issuing Company.
2. Market (Effective) Interest Rate – rate of interest that bondholders
(investors) could obtain by investing in other bonds that are
similar to the issuing firm’s bonds. Set by Bond Market.
4. Term Bond - all bonds mature on same date
5. Serial Bond - bonds retire in installments
6. Debenture Bonds - unsecured. Not backed by collateral. Look at
general credit worthiness of company.
7. Secured Bonds – bonds backed by specific collateral
8. Callable Bonds - corporation reserves right to buy them back
early at a stated price (call price or redemption price)
9. Convertible Bonds - can be exchanged for a stated # shares of
common stock
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C. Advantages/Disadvantages of Issuing Bonds vs. Issuing Stock
Advantages Disadvantages
1. 1.
2.
II. How Bonds are sold:
THE SELLING PRICE OF BONDS IS AFFECTED BY THE
DIFFERENCE BETWEEN COUPON RATE AND MARKET RATE
Bonds are sold one of three ways:
1. @ face (par) value
2. @ a discount
3. @ a premium
Selling Price of bond is dependent on Time Value of Money. The amount of
money a corporation receives when it sells bonds is the present value of the
future cash flows associated with them.
Because a bond is made up of (2) promises of future cash flows, you must
find the present value of BOTH to determine selling price.
Selling Price = PV of Face Amt. + PV of Int. Pmts
Note: always use MARKET RATE OF INTEREST in finding PV of bond
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Example 1:
Bonds Sell at Face Value: Coupon Rate = Market Rate
Face Value Bonds = $100,000 3-yr; 10%, semi-annual interest.
Market Rate = 10%
Yr 1 Yr 2 Yr3
PV of Face Amt: |__________|__________|____________|
PV of Interest Pmts:
Yr 1 Yr 2 Yr3
|__________|__________|____________|
Journal Entries to Record: Selling Price =
Date of
Issuance
Date of Interest
Payment
Note: Carrying value will not change over the life of the bond.
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Example 2:
Bonds Sell at Discount: Coupon Rate Market Rate
Example: Face Value Bonds = $100,000 3-yr.; semi-annual
interest. Coupon Rate =10%; Market Rate = 8 %
Yr 1 Yr 2 Yr3
PV of Face Amt: |__________|__________|____________|
PV of Interest Pmts:
Yr 1 Yr 2 Yr3
|__________|__________|____________|
Journal Entries: Selling Price =
Date of
Issuance
Balance Sheet:
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AMORTIZATION TABLE
Interest Cash Premium Carrying
Date Expense Payment Amortization Value
Issue
1
2
3
4
5
6________________________________________________________
Journal Entry Journal Entry
1st Interest Payment 2nd Interest Payment
Balance Sheet
Presentation at end of 1st year:
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EFFECT OF PREMIUM
1. Premium reduces the cost of borrowing (received more up
front and must pay back only face value at maturity).
2. Amortization of premium reduces interest expense
(Market rate--the actual cost of borrowing--is less than the
coupon rate.)
3. Carrying value of bond is reduced over its life until it
reaches face value at maturity
How to find Total Cost to Borrow (Interest Expense) – 2 ways to find:
1. Cash Outflow vs. Cash Inflow
2. Subtract Premium from Cash Interest Payments
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Example Problem:
Joyce Company issued $10,000 of bonds payable on January 1, 2010,
with an 8 percent coupon interest rate payable annually on December 31.
The bonds mature in five years. Market rate of interest is 7%.
Required:
1. Determine the selling price of the bonds.
2. Prepare a schedule showing the premium to be amortized each year
for the life of the bonds, assuming the effective interest method of
amortization.
3. Give the journal entry to record the interest payment on
December 31, 2010.
1. Selling Price:
2. AMORTIZATION TABLE
Interest Cash Premium Carrying
Date Expense Payment Amortization Value
Issue
12/31/10
12/31/11
12/31/12
12/31/13
12/31/14________________________________________________________
3.
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Bond Prices and Interest Rates:
There is an inverse relationship between market interest rates and bond
prices.
At issue:
Ex: If our bonds originally sold at a premium (c > m) and are now
selling on the market at a discount (c carrying value = loss (debit)
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Terry Tractors, Inc., has outstanding a $100,000, 10-year bond issue which
was sold on January 1, 2006, at a price of $110,000. The following
liability, shown below, appeared on the balance sheet on December 31,
2010.
Bonds payable....……. $100,000
Premium...................... 5,000 $105,000
Make the entry necessary to record the retirement of the bonds in each of
the following two situations:
a. The firm calls the bonds at 106 on January 1, 2011.
b. Terry Tractors, Inc., purchases half of the outstanding bonds in the
open market at 102 on January 1, 2011.
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