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Chapter 11

Chapter 11 BU227.docx

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Department
Business
Course
BU227
Professor
Carolyn Mac Tavish
Semester
Fall

Description
BU227 Chapter 11 – Reporting and Interpreting Non-current Liabilities Week 10 Characteristics of Long-term Notes and Bonds Payable -Companies can raise long-term debt directly from a number of financial service organizations, including banks, insurance companies, and pension fund companies – raising debt from one of these organizations is known as private placement -In many cases, a company’s need for debt capital exceeds the financial capability of any single creditor. In these situations, the company may issue publicly traded debt called bonds -Lenders often protect their interests by requesting that the debt be secured rather than unsecured -In the case of a large, personal long-term loan such as an automobile loan, lenders will insist on the right to repossess the automobile in the event of default -A bond usually requires the payment of interest over its life, with the repayment of principal on the maturity date -Bond principal – the amount payable at the maturity of the bond. It is also the basis for computing periodic cash interest payments -Par value/Face amount – other names for bond principal or the maturity value of a bond -Stated rate – the rate of interest per period specified in the bond contract -A bond always specified a stated rate of interest and the timing of periodic cash interest payments, usually annually or semi-annually -Each periodic interest payment is equal to the principal times the stated interest rate -Different types of bonds have different characteristics -Companies design bond features that are attractive to different groups of creditors, just as automobile manufacturers try to design cars that appeal to different groups of consumers -When a company decides to issue new bonds, it prepares a bond indenture (bond contract) that specifies the legal provisions of the bonds -The indenture also contains covenants designed to protect the creditors -Typical covenants include limitations on new debt that the company might issue in the future, limitations on the payment of dividends, and required minimum levels of certain accounting ratios, such as the current ratio -Managers prefer covenants that are less restrictive because they may limit the company’s future actions -Debenture – an unsecured bond; no assets are specifically pledged to guarantee repayment -Callable bonds – may be called for early retirement at the option of the issuer -Convertible bonds – may be converted to other securities of the issuer (usually common shares) -Indenture – a bond contract that specifies the legal provisions of a bond issue -The bond issuer also prepares a prospectus, which is a legal document given to potential bond investors -The prospectus describes the company, the bond, and how the proceeds of the bond will be used -Bond certificate – the bond document that each bondholder receives -Trustee – an independent party appointed to represent the bondholders Players in the Bond Market -Most companies work with an underwriter that either buys the entire issue of bonds and then resells them to individual creditors or simply sells the bonds or notes without any obligation to purchase them -It is not uncommon for companies to use several underwriters to sell a large bond issue -Bond dealers sell bonds, typically, to institutional investors such as banks, insurance companies, and mutual and pension funds -Almost a trades occur by telephone, known as an over-the-counter (OTC) market BU227 Chapter 11 – Reporting and Interpreting Non-current Liabilities Week 10 -Because of the complexities associated with bonds, several agencies exist to evaluate the probability that a bond issuer will not be able to meet the requirements specified in the indenture – this risk is called a default risk -The higher the risk of default, the higher will be the interest rate required to successfully persuade investors to purchase the bond, and the more restrictive will be the covenants protecting the bondholder -If it becomes apparent that there has been a change in default risk for any debt already issued, each rating service will issue a public bulletin that upgrades or downgrades the credit rating, along with reasons for the change -Bond prices change for two main reasons: changes in creditworthiness of the bond issuer and changes in interest rates -The company’s creditworthiness depends on the operating, investing, and financing decisions made by management -Interest rates depend on the supply and demand for money -There is the risk-free rate of return on bonds because purchasers believe that the federal government will never fail to repay, or default, on its debts -The interest rates of all other debt instruments are established relative to this risk-free rate -The difference between the interest rate on debt instruments and the risk-free rate is called the spread -The size of the spread depends upon the perceived additional risk that the company will default on wither its interest or principal payments on the debt Reporting Bond Transactions 1. Principal – This is usually a single payment made when the bond matures It is also called the par or face value 2. Cash interest payments -Coupon rate – the stated rate of interest on bonds -Neither the company nor the underwriter determines the price at which the bonds sell. Instead the market determines the current cash equivalent of future interest and principal payments by using present value concepts. -Because the market rate is the interest rate on a debt when it is incurred, it should be used in computing the present value of the bond -Market interest rate – the current rate of interest on a debt when incurred; also called the yield, or effective interest rate -Bond premium – the difference between the selling price and par when the bond is sold for more than par -Bond discount – the difference between the selling price and par when the bond is sold for less than par Bonds Issued at Par -Bonds sell at their par value when buyers are willing to invest in them at the interest rate stated on the bond -The amount of money a corporation received when it sells bonds is the present value of the future cash flows associated with them -When the effective rate of interest equals the stated rate of interest, the present value of the future cash flows associated with a bond always equals the bond’s par value BU227 Chapter 11 – Reporting and Interpreting Non-current Liabilities Week 10 -A bond’s selling price is determined by the present value of its future cash flows not the par value Reporting Interest Expense on Bonds Issued at Par -The creditors who bought the bonds did so with the expectation that they would earn interest over the life of the bond -Bond interest payment dates rarely coincide with the last day of a company’s fiscal year -Interest expense incurred but not paid must be accrued with an adjusting entry Bonds Issued at a Discount -Bonds sell at a discount when the market rate of interest demanded by the buyers is higher than the stated interest rate offered by the issuer -Occurs when the market rate of interest increases after the company determines the coupon rate on the bonds -To compute the issue price of the bonds, we need to compute the present value of the future cash flows specified on the bond -When a bond is sold at a discount, the bonds payable account is credited for the par value and the discount is recorded as a debit to discount on bonds payable -The discount is recorded in a separate contra-liability account as a debt -The statement of financial position reports the bonds payable at their carrying amount, which is their maturity amount less any unamortized discount -The extra cash must be paid is an adjustment to the interest payments, ensuring that creditors earn the market rate of interest on the bonds -The amortization of bond discount is an increase in bond interest expense Reporting Interest Expense on Bonds Issued at a Discount by Using Effective Interest Amortization -Under the effective interest method, interest expense or a bond is computed by multiplying the current unpaid balance times the market rate of interest that existed on the date the bonds were sold -Effective interest method – amortizes a bond discount or premium on the basis of the effective interest rate -The periodic amortization of a bond discount or premium is then calculated as the difference between interest expense and the amount of cash paid or accrued -Steps: 1. Compute
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