Financial Accounting_ Second Canadian Edition by chenmeixiu

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									              Chapter 11
         Reporting and Interpreting
                   Bonds




11 - 1                    Financial Accounting, Second Canadian Edition
          Business Background
 The mixture of debt and equity used to finance
      a company’s operations is called the
                 capital structure:




          Debt - funds        Equity - funds
         from creditors        from owners


11 - 2                          Financial Accounting, Second Canadian Edition
        Business Background
 Capital Structure – Long-Term Debt
           Significant debt needs of a
           company are often filled by
            issuing notes and bonds.

         Notes &
                                Cash
         Bonds




11 - 3                          Financial Accounting, Second Canadian Edition
           Business Background
    Capital Structure – Long-Term Debt
         The use of long-term debt offers significant
                  advantages to companies:


         1. Debt does not dilute ownership and
            control of the company because debt
            holders participate neither in the
            management of operations nor in the
            distribution of accumulated earnings that
            are eventually distributed to shareholders

11 - 4                                  Financial Accounting, Second Canadian Edition
       Business Background
Capital Structure – Long-Term Debt

         2. Cash payments to the debt holders are
            limited to the scheduled payments of
            interest and the repayment of the
            principal amount of the debt.
         3. Interest expense is deductible for tax
            purposes but dividends paid to
            shareholders are not.



11 - 5                                  Financial Accounting, Second Canadian Edition
                Financial Leverage

         Financial Leverage is the use of borrowed
         funds to increase the rate of return on
         owner’s equity; it occurs when the interest
         rate on debts is lower than the rate of
         return on total assets.




11 - 6                                 Financial Accounting, Second Canadian Edition
               Financial Leverage

                                       Capital Structure
                                    ________________________
Total assets = $600,000                             50% Debt
                                    100% Equity    50% Equity
Income before interest and taxes     $ 100,000       $ 100,000
Interest expense ($300,000 x 10%)         -0-           30,000
                                       100,000          70,000
Income tax expense (@40%)               40,000          28,000
Net income                           $ 60,000        $ 42,000

Owners’ equity                       $ 600,000                 $ 300,000
Return on equity
 (Net income/Owners’ equity)               10%                           14%



11 - 7                                    Financial Accounting, Second Canadian Edition
         Types of Long-Term Debt
   Long-term debt is available to companies in
   various forms:

    Bank loans
    Notes
    Mortgage Notes
    Bonds and Debentures


          http://www.aliant.ca/english/ir/index.shtml
11 - 8                                  Financial Accounting, Second Canadian Edition
         Business Background

   Bonds can be     As liquidity
      traded on     increases . . .

     established
   exchanges that
       provide
     liquidity to                             . . . Cost of
                                              borrowing
    bondholders.                              decreases.

11 - 9                        Financial Accounting, Second Canadian Edition
              Business Background

                  Advantages of bonds:
          • Bonds are debt, not equity, so the
            ownership and control of the
            company are not diluted.
          • Interest expense is tax-deductible.
          • The low interest rates on bonds allow
            for positive financial leverage.

11 - 10                             Financial Accounting, Second Canadian Edition
               Business Background

                Disadvantages of bonds:

          • The scheduled interest payments are legal
            obligations and must be paid each period.

          • A single, large principal payment is
            required at the maturity date.


11 - 11                                  Financial Accounting, Second Canadian Edition
          Characteristics of Bonds
                 Payable
                At Bond Issuance Date

                   $ Bond Issue Price $
     Company                                        Investor
      Issuing                                        Buying
       Bonds                                         Bonds
                     Bond Certificate

    Bonds payable are long-term debt
       for the issuing company.

11 - 12                                 Financial Accounting, Second Canadian Edition
          Characteristics of Bonds
                 Payable
                         Periodic
                $   Interest Payments    $
     Company                                           Investor
      Issuing                                           Buying
       Bonds                                            Bonds
                       Face Value
                $   Payment at End of     $
                       Bond Term




11 - 13                                 Financial Accounting, Second Canadian Edition
               Characteristics of Bonds
                      Payable
 Face Value $1,000                               Interest 10%
                                                  6/30 & 12/31
                  BOND PAYABLE

 Bond Date 1/1/01                  Maturity Date 1/1/10

1.     Face Value = Maturity or Par Value, Principal
2.     Maturity Date
3.     Stated Interest Rate      Other Factors:
4.     Interest Payment Dates 6. Market Interest Rate
5.     Bond Date                 7. Issue Date
     11 - 14                        Financial Accounting, Second Canadian Edition
             Characteristics of Bonds
                    Payable
• When issuing bonds, potential
  buyers of the bonds are given a
  prospectus.
• The company’s bonds are issued
  to investors through an
  underwriter.
• The trustee makes sure the issuer
  fulfills all of the provisions of the
  bond indenture.
  For example, see Prospectus Supplement,
  dated Feb. 8, 2002 of Aliant Telecom Inc. on
  the SEDAR website (www.sedar.com).

   11 - 15                                       Financial Accounting, Second Canadian Edition
                 Bond Classifications

• Debenture bonds
          Not secured with the pledge of a specific asset.
• Retractable
          May be retired at the option of the bondholder.
• Redeemable (Callable) bonds
          May be turned in at any time for repayment at the
           option of the issuer.
• Convertible bonds
          May be exchanged for other securities of the issuer
           (usually common shares) at the option of the
           bondholder.
11 - 16                                     Financial Accounting, Second Canadian Edition
              Bond Classifications

          • Senior Debt receives
            preference over other
            creditors in the event of
            bankruptcy or default.

          • Subordinated Debt is riskier
            than senior debt.

11 - 17                            Financial Accounting, Second Canadian Edition
             Financial Leverage Ratio
    The financial leverage ratio is an important
    measure of how management is using debt
       to increase the amount of assets the
       company employs to earn income for
                    shareholders
                                         Avg. Total Assets
          Financial leverage ratio =
                                     Avg. Shareholders' Equity
          High debt-to-equity ratios indicate more
                      leverage and risk.
11 - 18                                        Financial Accounting, Second Canadian Edition
          Reporting Bond Transactions

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

      Present Value of the Principal (a single payment)
    + Present Value of the Interest Payments (an annuity)
    = Issue Price of the Bond


   The interest rate used to compute the present
           value is the market interest rate.

11 - 19                                 Financial Accounting, Second Canadian Edition
          Reporting Bond Transactions

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

Interest = Principal × Stated Rate × Time




11 - 20                        Financial Accounting, Second Canadian Edition
          Bond Premium and Discounts

      Interest               Bond                Accounting for
       Rates                 Price               the Difference
Stated         Market Bond        Par Value    There is no difference
 Rate      =    Rate Price   =   of the Bond      to account for.
Stated         Market Bond        Par Value The difference is accounted
           <                 <                for as a bond discount.
 Rate           Rate Price       of the Bond
Stated         Market Bond        Par Value The difference is accounted
           >                 >                for as a bond premium.
 Rate           Rate Price       of the Bond




11 - 21                                           Financial Accounting, Second Canadian Edition
                        Issuing Bonds
On Jan 1, 2005, Placer Dome issues $400,000 in
bonds having a stated rate of 10%. The bonds
    mature in 10 years and interest is paid
semiannually. The market rate is 12% annually.
  Are Placer Dome bonds issued at par, at
        a discount, or at a premium?
          Interest             Bond                Accounting for
           Rates               Price               the Difference
Stated           Market Bond        Par Value The difference is accounted
 Rate        <    Rate Price   <   of the Bond  for as a bond discount.


11 - 22                                            Financial Accounting, Second Canadian Edition
                    Issuing Bonds

            On Jan 1, 2005, Placer Dome issues
           $400,000 in bonds having a stated rate of
           10%. The bonds mature in 10 years and
          interest is paid semiannually. The market
                      rate is 12% annually.

              Compute the issue price of
                Placer Dome bonds.


11 - 23                               Financial Accounting, Second Canadian Edition
                  Issuing Bonds

   Compute the present value of the
    principal.
          Present Value
          Single Amount =   Principal × Factor


               Use the present value of a
             single amount table to find the
                   appropriate factor.

11 - 24                              Financial Accounting, Second Canadian Edition
                     Issuing Bonds

   Compute the present value of the
    principal.
Present Value
Single Amount =         Principal   × Factor, i=6.0%


           Use the market rate of 12% to determine
             the present value. Interest is paid
          semiannually, so the rate is i=6% (12% ÷ 2
                  interest periods per year).
11 - 25                                  Financial Accounting, Second Canadian Edition
                  Issuing Bonds

    Compute the present value of the
     principal.
Present Value
Single Amount =    Principal   × Factor, i=6.0% , n=20

  Though the maturity period is 10 years,
 there are 2 interest periods per year. For
 the present value computation, use n=20
      (10 years × 2 periods per year).

 11 - 26                            Financial Accounting, Second Canadian Edition
                  Issuing Bonds

    Compute the present value of the
     principal.
Present Value
Single Amount =     Principal   × Factor, i=6.0% , n=20
              =    $ 400,000    × 0.3118
              =    $ 124,720




 11 - 27                             Financial Accounting, Second Canadian Edition
                   Issuing Bonds

    Compute the present value of the
     interest payments.
Present Value
  of Annuity  =      Payment   × Factor

           The interest payment is computed as:
                  $400,000 × 10% × 6/12
                        = $20,000

 11 - 28                             Financial Accounting, Second Canadian Edition
                     Issuing Bonds

    Compute the present value of the
     interest payments.
Present Value
  of Annuity  =        Payment     × Factor, i=6.0% , n=20
              =       $   20,000

            Use the same i=6.0% and n=20 used
           for the present value of the principal,
              but use the present value of an
                       annuity table.

 11 - 29                                Financial Accounting, Second Canadian Edition
                  Issuing Bonds

    Compute the present value of the
     interest payments.
Present Value
  of Annuity  =    Payment     × Factor, i=6.0% , n=20
              =   $   20,000   × 11.4699
              =   $ 229,398



            Now, the issue price of the
             bonds can be computed.
 11 - 30                            Financial Accounting, Second Canadian Edition
             Issuing Bonds

Compute the issue price of the bonds.


  $ 124,720 Present Value of the Principal
+   229,398 Present Value of Interest Payments
= $ 354,118 Issue Price of the Bonds



11 - 31                       Financial Accounting, Second Canadian Edition
             Issuing Bonds

 Compute the issue price of the bonds.


   $ 124,720 Present The $354,118 is less than
                     Value of the Principal
                        the face amount of
 +   229,398 Present Value of Interest Payments
                      $400,000, so the bonds
 = $ 354,118 Present Value of the Bonds
                   are issued at a discount of
                              $45,882


11 - 32                       Financial Accounting, Second Canadian Edition
                Recording Bonds
              Issued at a Discount
   Prepare the journal entry to record
    the issuance of the bonds.
             GENERAL JOURNAL            Page                 97
      Date          Description       Debit               Credit
  May 1




11 - 33                           Financial Accounting, Second Canadian Edition
             Bonds Issued at a Discount
          Financial Statement Presentation

                Placer Dome
            Partial Balance Sheet
               At Jan 1, 2005
                                              The discount
Long-Term Liabilities
Bonds Payable, 10%            $ 400,000
                                                 will be
 Due December 31, 2014                          amortized
 Less: Bond Discount            (45,882)       over the 10-
Total L-T Liabilities         $ 354,118       year life of the
                                                 bonds.

11 - 34                                    Financial Accounting, Second Canadian Edition
             Bonds Issued at a Discount
          Financial Statement Presentation

                Placer Dome                     Two methods
            Partial Balance Sheet
               At Jan 1, 2005
                                               of amortization
                                               are commonly
Long-Term Liabilities                               used:
Bonds Payable, 10%             $ 400,000
Due December 31, 2014
                                                   Straight-line
 Less: Bond Discount             (45,882)               or
Total L-T Liabilities          $ 354,118
                                                  Effective
                                              Interest Method
11 - 35                                     Financial Accounting, Second Canadian Edition
          Straight-Line Amortization of
                 Bond Discount
             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.

11 - 36                                Financial Accounting, Second Canadian Edition
          Straight-Line Amortization of
                 Bond Discount
          Placer Dome issued its bonds on Jan
           1, 2005. The discount was $45,882.
            The bonds have a 10-year maturity
               and $20,000 interest is paid
                     semiannually.
          Compute the periodic discount amortization
               using the straight-line method.

           Discount            Total          Number of
          Amortization   =   Discount    ÷ Interest Periods
                         =   $ 135,891   ÷ 20
11 - 37                                     Financial Accounting, Second Canadian Edition
          Straight-Line Amortization of
                 Bond Discount
          Placer Dome issued its bonds on Jan
           1, 2005. The discount was $45,882.
            The bonds have a 10-year maturity
               and $20,000 interest is paid
                     semiannually.
           Compute the periodic discount amortization
           Discount          Total           Number of
                  using the straight-line Interest Periods
          Amortization = Discount ÷ method.
                        =   $ 45,882   ÷ 20
                        =   $   2,294 per period (rounded)
11 - 38                                   Financial Accounting, Second Canadian Edition
          Straight-Line Amortization of
                 Bond Discount
     Prepare the journal entry to record the payment
       of interest and the discount amortization for
          the six months ending on July 1, 2005.

             GENERAL JOURNAL              Page               123
      Date          Description         Debit              Credit
  July 1




11 - 39                             Financial Accounting, Second Canadian Edition
              Bonds Issued at a Discount
           Financial Statement Presentation

                 Placer Dome                        As the
             Partial Balance Sheet               discount is
                    7/1/2005                    amortized, the
                                                   carrying
Long-Term Liabilities
Bonds Payable, 10%              $ 400,000
                                                amount of the
Due December 31, 2014                               bonds
 Less: Bond Discount              (43,588)        increases
Total L-T Liabilities           $ 356,412



 11 - 40                                     Financial Accounting, Second Canadian Edition
           Zero Coupon Bonds

   • Zero coupon bonds do not pay
     periodic interest.
   • Because there is no interest
     annuity . . .

PV of the Principal = Issue Price of the Bonds

   • This is called a deep discount
     bond.

11 - 41                          Financial Accounting, Second Canadian Edition
          Issuing Bonds at a Premium

      Interest               Bond                  Accounting for
       Rates                 Price                 the Difference
Stated         Market Bond        Par Value      There is no difference
 Rate
          =     Rate Price
                             =   of the Bond        to account for.
Stated         Market Bond       Par Value     The difference is accounted
 Rate
           <    Rate Price
                             < of the Bond       for as a bond discount.
Stated      Market Bond         Par Value The difference is accounted
 Rate
           > Rate Price      > of the Bond for as a bond premium.


11 - 42                                             Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium
On Jan 1, 2005, Placer Dome issues $400,000 in
 bonds having a stated rate of 10%. The bonds
    mature in 10 years and interest is paid
semiannually. The market rate is 8.5% annually.
   Are Placer Dome bonds issued at par, at a
          discount, or at a premium?
      Interest                Bond                Accounting for
       Rates                  Price               the Difference
Stated          Market Bond      Par Value    The difference is accounted
 Rate
            >    Rate Price
                              > of the Bond     for as a bond premium.


          Let’s compute the issue price of the bonds.
11 - 43                                            Financial Accounting, Second Canadian Edition
          Issuing Bonds at a Premium

   Compute the present value of the
    principal.
           Present Value
           Single Amount   =   Principal        × Factor


               Use the present value of a
             single amount table to find the
                   appropriate factor.


11 - 44                                    Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium

    Compute the present value of the
     principal.
Present Value
Single Amount =         Principal   × Factor, i=4.25%

           Use the market rate of 8.5% to determine
                present value. Interest is paid
             semiannually, so the rate is i=4.25%
             (8.5% ÷ 2 interest periods per year).

 11 - 45                                Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium

    Compute the present value of the
     principal.
Present Value
Single Amount =        Principal   × Factor, i=4.25% ,n=20


            The maturity period is 10 years, there
           are 2 interest periods per year. For the
            present value computation, use n=20
                    (10 years × 2 periods).
 11 - 46                                 Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium

    Compute the present value of the
     principal.
Present Value
Single Amount =      Principal   × Factor, i=4.25% ,n=20
              =     $ 400,000    × 0.4350
              =     $ 174,000


             Next, we compute the present
             value of the interest payments.
 11 - 47                              Financial Accounting, Second Canadian Edition
          Issuing Bonds at a Premium

   Compute the present value of the
    interest payments.
Present Value
  of Annuity  =      Payment   × Factor

          The interest payment is computed as:
                 $400,000 × 10% × 6/12
                       = $20,000

11 - 48                             Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium

    Compute the present value of the
     interest payments.
Present Value
  of Annuity  =     Payment     × Factor, i=4.25% ,n=20
              =    $   20,000

        Use the same i=4.25% and n=20 that were
        used to compute the present value of the
       principal. Now, however, the factor comes
       from the present value of an annuity table.
 11 - 49                              Financial Accounting, Second Canadian Edition
           Issuing Bonds at a Premium

    Compute the present value of the
     interest payments.
Present Value
  of Annuity  =     Payment     × Factor, i=4.25% ,n=20
              =    $   20,000   × 13.2944
              =    $ 265,888



               Now, the issue price of the
                bonds can be computed.
 11 - 50                             Financial Accounting, Second Canadian Edition
          Issuing Bonds at a Premium

 Compute the issue price of the bonds.

   $ 174,000 Present Value of the Principal
 +   265,888 Present Value of Interest Payments
 = $ 439,888 Present Value of the Bonds

  The $439,888 is greater than the face amount of
 $400,000, so the bonds are issued at a premium of
                     $39,888.
11 - 51                          Financial Accounting, Second Canadian Edition
          Issuing Bonds at a Premium

   Prepare the journal entry to record
    the issuance of the bonds.
             GENERAL JOURNAL                     Page                97
      Date            Description             Debit               Credit
  Jan     1 Cash                              439,888
              Bonds Payable                                        400,000
              Premium on Bonds Payable                              39,888

             This is called an adjunct account that
              appears in the liability section as an
                   addition to Bonds Payable.
11 - 52                                   Financial Accounting, Second Canadian Edition
          Bonds Issued at a Premium
      Financial Statement Presentation

               Placer Dome                        The
           Partial Balance Sheet                premium
              At Jan 1, 2005
                                                 will be
Long-Term Liabilities                          amortized
Bonds Payable, 10%             $ 400,000        over the
Due December 31, 2014
 Add: Bond Premium                39,888
                                               10-year life
Total L-T Liabilities          $ 439,888         of the
                                                 bonds.

11 - 53                                    Financial Accounting, Second Canadian Edition
    Bonds Issued at a Variable Interest
                  Rate

     To compensate creditors for the effect
      of unexpected inflation, some debt is
       issued with a variable interest rate.




11 - 54                        Financial Accounting, Second Canadian Edition
               Time Interest Earned

                             Net income + Interest expense
  Times Interest                 + Income tax expense
                 =
  Earned                           Interest expense


            The ratio shows the amount of added value
          generated for each dollar of interest expense. In
           general, a high ratio is viewed more favourable
                           than a low ratio.



11 - 55                                      Financial Accounting, Second Canadian Edition
     Effective-Interest Amortization of
      Bond Discounts and Premiums
     The effective-interest method
         computes interest as:
          Bond Carrying Value × Market Rate

   Principal amount of the bonds
      - unamortized discount
                or
      + unamortized premium

11 - 56                            Financial Accounting, Second Canadian Edition
     Effective-Interest Amortization of
      Bond Discounts and Premiums
     The effective-interest method
         computes interest as:
          Bond Carrying Value × Market Rate

     This is the same market rate
        used to determine the
      present value of the bond.

11 - 57                           Financial Accounting, Second Canadian Edition
              Effective-Interest Method
Recall our first example of Placer Dome. On Jan 1,
    2005, Placer Dome issues $400,000 in bonds
  having a stated rate of 10%. The bonds mature
   in 10 years and interest is paid semiannually.
          The market rate is 12% annually.
                  GENERAL JOURNAL                  Page                97
           Date           Description            Debit              Credit
     Jan      1 Cash                            354,118
                Discount on Bonds Payable        45,882
                   Bonds Payable                                    400,000
                to record issuance of bonds


 11 - 58                                      Financial Accounting, Second Canadian Edition
            Effective-Interest Method

          Principal amount of bonds                  $ 400,000
          Less: unamortized discount                   (45,882)
          Bond Carrying Value                          354,118
          Market interest rate                           6.00%
          Interest expense - July 1, 2005            $ 21,247


     The cash paid to bond           Interest is paid semi-
      holders is $20,000          annually, so the market rate
       ($400,000 × 5%)                 is 12% ÷ 2 = 6%.


11 - 59                                     Financial Accounting, Second Canadian Edition
             Effective-Interest Method
           The journal entry to record the first
                   interest payment is:
                 GENERAL JOURNAL            Page               123
          Date          Description       Debit               Credit
     July 1




11 - 60                               Financial Accounting, Second Canadian Edition
           Effective-Interest Method
          The new bond carrying value of the
            next interest payment period is:
            Principal amount of bonds      $ 400,000
            Less: unamortized discount       (44,635)
            Bond Carrying Value              355,365




11 - 61                                  Financial Accounting, Second Canadian Edition
           Understanding Alternative
            Amortization Methods
• The effective-interest method
  of amortization is preferred by
  GAAP.

• The straight-line amortization
  may be used if it is not
  materially different from the
  effective interest amortization.

 11 - 62                      Financial Accounting, Second Canadian Edition
              Focus on Cash Flows

   Financing activities –
           Issuance of long-term debt (a cash
            inflow)

           Retirement of debt (a cash outflow)

           Repayment of principal at maturity (a
            cash outflow)


11 - 63                              Financial Accounting, Second Canadian Edition

								
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