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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