Bonds and Notes
Chapter 10: Bonds and Notes
Page 1
Introduction to Bonds
Bonds are defined as debt securities that are issued by corporations and governmental entities primarily to raise large amounts of money. They serve as a means for organizations to borrow capital.
One of the main reasons companies opt to issue bonds, rather than seeking loans, is that banks may not be able to provide enough funds for their needs.
Bonds come with scheduled payments of interest and principal, which are set to occur at specified periods.
Typically, bonds are categorized as long-term liabilities on the balance sheet, meaning they are expected to be paid off over an extended time frame.
Unlike conventional bank debt, bonds can be traded on established exchanges. This feature allows bondholders the option to sell bonds to an investor if they need to liquidate them before maturity.
Companies that issue publicly traded bonds are required to file regular disclosures with the Securities and Exchange Commission (SEC).
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Financing with Bonds
Advantages of Using Bonds
Ownership and Control: Raising capital through bonds allows companies to retain ownership and control without diluting shareholder equity through issuing common stock.
Tax Benefits: Interest expenses on bonds are tax-deductible, providing a financial advantage to the company compared to equity financing.
Investment Flexibility: Organizations can secure funds at a predetermined interest rate and have the potential to invest those funds at a higher rate of return.
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Disadvantages of Using Bonds
Bankruptcy Risk: Issuing bonds increases the company's obligation to repay debt. Failure to meet these obligations can lead to bankruptcy, as creditors may take legal action for recovery.
Cash Flow Impact: Companies are bound by contractual requirements to make regular interest and principal payments, which can adversely affect cash flow.
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Types of Bonds
Debenture Bonds: Not secured by any specific asset, these bonds rely on the creditworthiness of the issuer.
Callable Bonds: Bonds that can be retired and repaid at any time at the issuer's discretion.
Redeemable Bonds: Bonds that bondholders can cash in at any time for repayment.
Convertible Bonds: These bonds can be exchanged for a specified number of shares of the issuing company's common stock at the bondholder's option.
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Bond Characteristics
Face Value: Also referred to as par value or principal, typically set at $1,000.
Maturity Date: The date on which the bond will mature and the issuer must pay back the face value.
Stated Interest Rate: Also known as the coupon rate, this is the rate at which the issuer pays interest to bondholders.
Interest Payment Dates: Typically, bonds pay interest semi-annually, which should be stated clearly.
Bond Date: The date the bond is issued to investors.
Market Interest Rate: The current interest rate in the market that affects bond pricing.
Issue Date: The date on which the bond is officially issued to investors.
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Credit Ratings for Bonds
Bond ratings are a mechanism for assessing the credit quality and reliability of bond issuers. The following ratings are presented:
Aaa/AAA: Prime, very low risk.
Aa1/AA+ to Aa3/AA-: High-grade ratings indicating low risk but slightly more concern than Aaa.
A1/A+ to A3/A-: Rated as upper medium grade, showing a moderate risk.
Baa1/BBB+ to Baa3/BBB-: Lower medium grade, indicating a higher risk of default.
Ratings below Baa are considered speculative:
Ba1/BB+ to Ba3/BB-: Non-investment grade, indicating speculative bonds.
Further risks increase with ratings from B1/B+ to D indicating levels of high to substantial risk.
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Accounting for Bond Transactions
Issuance at Face Value, Discount, or Premium
Bonds can be issued at their face value, at a discount, or at a premium depending on the market conditions relative to the stated interest rate.
Objective: Different scenarios require different accounting treatments based on the bond's issuance price relative to its face value.
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Bond Pricing Example
Scenario: On January 1, 2021, Showboat issues 10% bonds with a face value of $400,000. The bonds mature in 10 years, with interest payments occurring semiannually on June 30 and December 31:
At par: If the market interest rate is 10%, the bonds are issued at par value.
At a discount: If the market interest rate is 12%, the bonds are sold at a discount.
At a premium: If the market interest rate is 8%, the bonds are sold at a premium.
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Issuance at Par
Transaction Date: January 1, 2021
Journal Entry for Issuance:
Debit Cash (+A) = $400,000
Credit Bonds Payable (+L) = $400,000
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Recording Interest Payments (at Par)
Interest Payment Recording: Entered every six months (June 30 and December 31)
Calculation:
Semi-Annual Interest Expense/Payment = Face Value * Stated Rate * (6/12) = $400,000 * 10% * 0.5 = $20,000
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Before Discount Issuing Bonds
Important Note: When computing the present value of future cash flows for interest payments that occur twice a year, adjustments must be made:
Use half of the market rate to calculate present value.
Adjust coupon payments and periods accordingly.
Page 12
Bond Issuance at a Discount
Market Interest Rate Scenario: If the market rate is 12% while the stated rate is 10%, bonds will be sold at a discount.
Issuance Price Calculation:
Lump Sum:
Number of periods (N) = 20, Present Value Factor (PVF) at 6% = 0.31180
Present Value (PV) Lump Sum = $400,000 * 0.31180 = $124,720
Annuity:
Interest Payments = $20,000, PV Annuity Factor (PVAF) at 6% = 11.46992
PV Annuity = $20,000 * 11.46992 = $229,398
Total Issuance Price = PV Lump Sum + PV Annuity = $124,720 + $229,398 = $354,120
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Present Value Factors (Lump Sum)
Listing of Present Value Factors for various interest rates and periods that facilitate the calculation of present value for bond cash flows.
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Present Value of Annuity Factors
Outline of Present Value of an Ordinary Annuity of 1 across different interest rates, serving as a quick reference for calculating present values of the annuity payments made.
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Accounting Treatment for Bonds Issued at a Discount
January 1, 2021: Journal Entry:
Debit Cash (Asset) = $354,120
Debit Discount on Bonds Payable (Contra-liability) = $45,880
Credit Bonds Payable (Liability) = $400,000
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Balance Sheet Presentation (At a Discount)
Presentation on Balance Sheet:
Long-term Liabilities: Bonds Payable, 10% due December 31, 2031
Total Bonds Payable = $400,000
Less Discount = $45,880
Net Bonds Payable = $354,120
Key Point: The company is obligated to repay $400,000 at maturity, although $354,120 was received from the bond sale. The discount represents additional interest payable recognized over the life of the bond rather than all at once.
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Calculation of Interest Expense Using the Effective-Interest Method
Computation of Interest Expense:
Formula: Interest Expense = Carrying Value of Bonds x Market Interest Rate
A reminder that the interest paid remains constant at Face Value x Stated Rate x Time, yet the differences between these two equations represent the amortization of bond discount or premium, required by GAAP (Generally Accepted Accounting Principles).
Page 18
Recording Interest Expense for Bonds Issued at a Discount
For the first interest payment on June 30, 2021:
Calculation of Interest Expense:
Interest Expense = $354,120 * 12% * (6/12) = $21,247
Interest Paid = $400,000 * 10% * (6/12) = $20,000
Amortization of Discount = $21,247 - $20,000 = $1,247
Journal Entry:
Debit Interest Expense (+E, -SE) = $21,247
Debit Discount on Bonds Payable (-XL) = $1,247
Credit Cash (-A) = $20,000
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Present Value Factors (Lump Sum)
Reiterated list of present value factors for single cash flows to support the valuation of future cash inflows from bonds.
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Present Value of Annuity Factors
Reiterated annuity factors that are useful for calculating periodic payment valuations.