Chapter 11 (ACCT 202)

Price of a bond

-The price of a bond is quoted as a percentage of the bond's face value.

Bond Characteristics and Terminology

-A bond issue is normally divided into a number of individual bonds. -The face amount of each bond is called the principal. This is the amount that must be repaid on the dates the bonds mature. -Interest on bonds may be payable annually, semiannually, or quarterly. Most bonds pay interest semiannually.

Premium on Bonds Payable

-Normal credit balance -Added to Bonds Payable to determine the carrying amount (or book value) of the bonds payable.

Amortizing a bond premium

-Like bond discounts, a bond premium must be amortized over the life of the bond. -(From lecture: The effect of the premium amortization is to decrease the interest expense on every semiannual interest payment. In effect, this decreases the contract rate of interest to a rate of interest that approximates the market rate.) -The amortization of a bond premium decreases the contract rate of interest on a bond to the market rate of interest that existed on the date the bonds were issued. -The amortization can be computed using either the straight-line or the effective interest rate method. -As the premium is amortized, the carrying amount of the bonds decreases until it equals the face amount of bonds on the maturity date.

Discount on Bonds Payable

-A contra account to Bonds Payable -Has a normal debit balance -Subtrated from Bonds Payable to determine the carrying amount (or book value) of the bonds payable.

Proceeds from Issuing Bonds

When a corporation issues bonds, the proceeds received for the bonds depend on: -The face amount of the bonds, which is the amount due at the maturity date -The interest rate on the bonds -The market rate of interest for similar bonds

Bond redemption

-A corporation may redeem or call bonds before they mature. -This is often done when the market rate of interest declines below the contract rate of interest. -In such cases, the corporation may issue new bonds at a lower interest rate and use the proceeds to redeem the original bond issue.

Gain or Loss

-A corporation usually redeems its bonds at a price different from the carrying amount (or book value) of the bonds. A gain or loss may be realized on a bond redemption: >A gain is recorded if the price paid for redemption is below the bond carrying amount. >A loss is recorded if the price paid for the redemption is above the carrying amount. -Gains and losses on the redemption of bonds are reported in the Other Revenue (Expense) section of the income statement.

Bond

-A form of interest-bearing note. -Requires periodic interest payments, with the face amount to be repaid at the maturity date. -As creditors of the corporation, bondholder claims on the corporation's assents rank ahead of stockholders. -Corporate bonds normally differ in face amounts, interest rates, interest payment dates, and maturity dates. -Also differ in other ways such as whether corporate assets are pledged in support of the bonds.

Annuity

-A series of equal cash receipts spaced equally in time.

Bonds have to be amortized

-Bonds may be issued at their face amount, a discount, or a premium. -When bonds are issued at less or more than their face amount, the discount or premium must be amortized over the life of the bonds. -At the maturity date, the face amount must be repaid. -In some situations, a corporation may redeem bonds before their maturity date by repurchasing them from investors.

Reporting Bonds Payable

-Bonds payable are reported as liabilities on the balance sheet. -Any portion of the bonds that is due within one year is reported as a current liability. -Any remaining bonds are reported as a long-term liability. -Any unamortized premium is reported as a deduction from the face amount of the bond. -A description of the bonds should also be reported either on the face of the financial statements or in the accompanying notes.

Amortization

-Every period, a portion of the bond discount must be reduced and added to interest expense to reflect the passage of time. -This process increases the contract rate of interest on a bond to the market rate of interest that existed on the date the bonds were issued. -The entry can be made annually as an adjusting entry, or combined with the semiannual interest payment.

Bond will sell at face amount

-If the market rate equals the contract rate

Bond will sell at discount

-If the market rate is greater than the contract rate, the bonds will sell for less than their face value. -Face amount of the bonds less the selling price.

Sell at a premium

-If the market rate is less than the contract rate, the bonds will sell for more than their face value. -The selling price of the bonds less the face amount.

Bonds Issued at a Discount

-If the market rate of interest is greater that the contract rate of interest, the bonds will sell for less than their face amount. -This is because investors are not willing to pay the full face amount for bonds that pay a lower contract rate of interest that the rate they could earn on similar bonds (market rate). -The difference between the face amount and the selling price of the bonds is the bond discount.

Bonds Issued at a Premium

-If the market rate of interest is less than the contract rate of interest, the bonds will sell for more than their face amount. -This is because investors are willing to pay more for bonds that pay a higher contract rate of interest than the rate they could earn on similar bonds (market rate). -Because the contract rate of interest is more than the market rate of interest, the bonds will sell for more than their face amount.

Market rate of interest (or effective rate of interest)

-Is the rate determined from sales and purchases of similar bonds. -Affected by a variety of factors, including investors' expectations of current and future economic conditions.

Straight-line method of amortization

-Provides equal amounts of discount (or premium) to be written off to interest expense each period.

Effective interest rate method

-Required by generally accepted accounting principles. (Straight-line may be used if the results do not differ significantly)

Bonds Issued at Face Amount

-Since the contract rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

Two methods of computing the amortization of a bond discount

-Straight-line method -Effective interest rate method (or interest method)

Future value

-The amount to be received in the future if you make a deposit now.

Time value of money

-The concept of present value is based on the ___. -The ____ recognizes that cash received today is worth more than the same amount of cash to be received in the future.

Times Interest Earned

-The assets of a company are subject to (1) claims of creditors and (2) rights of owners. -As creditors, bondholders are primarily concerned with the company's ability to makes its periodic interest payments and repay the face amount of the bonds at maturity. -Analysts assess the risk that bondholders will not receive their interest payments by computing this ratio during the year. -= (Income before income tax+Interest expense)/Interest expense. -This ratio computes the number of times interest payments could be paid out of current-period earnings. -Because interest payments reduce income tax expense, the ratio is computed using income before tax. -High values of this ratio are considered favorable, and low are considered unfavorable. -Values of this ratio less than 1.0 suggest that the firm is unable to cover interest payments from income before tax. Such a situation would eventually lead to loan defaults.

Present value

-The current worth of a future sum of money or stream of cash flows given a specified rate of return.

Effective interest rate method of amortization

-The effective interest rate method of amortization provides for a constant rate of interest over the life of the bonds. -As the discount or premium is amortized, the carrying amount of the bonds changes. -As a result, interest expense also changes each period. -This is in contrast to the straight-line method, which provides for a constant amount of interest expense each period. -The interest rate used in the effective interest rate method of amortization, sometimes called the interest method, is the market rate on the date the bonds are issued. -The carrying amount of the bonds is multiplied by this interest rate determine the interest expense for the period. -The difference between the interest expense and the interest payment is the amount of discount or premium to be amortized for the period.

Carrying Amount

-The face amount of the bonds less any unamortized discount or plus any unamortized premium.

Contract rate (or coupon rate)

-The interest rate to be paid on the face amount of the bond

Pricing bonds

-The selling price of a bond is the sum of the present values of: >The face amount of the bonds due at the maturity date. >The periodic interest to be paid on the bonds. -The market rate of interest is used to compute the present value of both the face amount and the periodic interest.

Present value of an annuity

-The sum of the present values of each cash receipt.

Bond Indenture

-The underlying contract between the company issuing the bonds and the bondholders. -Contract can be written in different ways, depending on the financial needs of the company. -The two most common types of bonds are term bonds and serial bonds. -When all bonds of an issue mature at the same time, they are called term bonds. -If the bonds mature over several dates, they are called serial bonds. -Other complicated bond structures: >Convertible bonds may be exchanged for shares of common stock >Callable bonds may be redeemed by the corporation prior to maturity

Computing Bond Prices

-When a corporation issues bonds, the price that investors are willing to pay for the bonds depends on: >The face amount of the bonds, which is the amount due at the maturity date. >The periodic interest to be paid on the bonds. >The market rate of interest. -An investor determines how much to pay for the bonds by computing the present value of the bond's future cash receipts, using the market rate of interest. A bond's future cash receipts include its face value at maturity and the periodic interest payments.

Callable bonds

-can be redeemed by the issuing corporations within the period of time and at the price stated in the bond indenture. -Normally, the call price is above the face value. -A corporation may also redeem its bonds by purchasing them on the open market.