Reporting and Interpreting Bonds

1
Chapter 10

• Reporting and Interpreting Bonds

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
Equity - funds from owners
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Understanding the BusinessCapital Structure -
Bonds
Significant debt needs of a company are often
filled by issuing bonds.
Bonds
Cash
4
Understanding the Business
As liquidity increases . . .
Bonds can be traded on established exchanges that
provide liquidity to bondholders.
. . . Cost of borrowing decreases.
5
Understanding the Business

• 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.

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Understanding the Business

• Disadvantages of bonds
• Risk of bankruptcy the debt must be paid back
  regularly, or creditors will force legal action.
• Negative impact on cash flows.

7
Characteristics of Bonds Payable
8
Characteristics of Bonds Payable

• When issuing bonds, potential buyers of the bonds
  are given a prospectus.
• The companys bonds are issued to investors
  through an underwriter.
• The trustee makes sure the issuer fulfills all of
  the provisions of the bond indenture.

9
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.
10
Characteristics of Bonds Payable
11
Measuring Bonds Payable and Interest Expense
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.
12
Measuring Bonds Payable and Interest Expense
The stated rate is only used to compute the
periodic interest payments.
13
Bond Premium and Discounts


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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.

15
Zero Coupon Bonds

• Zero coupon bonds do not pay periodic interest.
• Because there is no interest annuity . . .
• This is called a deep discount bond.

PV of the Principal Issue Price of the Bonds
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Issuing Bonds at a Premium


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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 less any
unamortized discount or plus any unamortized
premium.
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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.
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Understanding Alternative Amortization Methods

• Effective-interest method of amortization is
  preferred by GAAP.
• Straight-line amortization may be used if it is
  not materially different from effective interest
  amortization.

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Early Retirement of Debt

• Occasionally, the issuing company will call
  (repay early) some or all of its bonds.
• Gains/losses incurred as a result of retiring
  bonds should be reported as an extraordinary item
  on the income statement.

21
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)