Ch 14.1 (Bonds Payable) Flashcards
Long-term Liability
If it does not meet the definition of a current liability, then it must be long term (GAAP).
A principle based on the terms and conditions of a contract is appropriate to define long-term liability (FASB).
long-term debt has various covenants or restrictions that protect both lenders and borrowers.
Bond Indenture
A promise to pay (1) a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the maturity amount (face value).
Bond Indenture
A promise to pay (1) a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the maturity amount (face value).
Main purpose of bonds is to borrow for the long term when the amount of capital needed is too large for one lender to supply.
A company may sell an entire bond issue to an investment bank, which acts as a selling agent in the process of marketing the bonds.
Secured and Unsecured Bonds
Secured bonds are backed by a pledge of some sort of collateral.
Bonds not backed by collateral are unsecured. A debenture bond is unsecured. A “junk bond” is unsecured and also very risky, and therefore pays a high interest rate. Companies often use these bonds to finance leveraged buyouts.
Term, Serial Bonds, and Callable Bonds
Bond issues that mature on a single date are called term bonds.
Issues that mature in installments are called serial bonds.
Callable bonds give the issuer the right to call and redeem the bonds prior to maturity.
Income and Revenue Bonds
Income bonds pay no interest unless the issuing company is profitable.
Revenue bonds, so called because the interest on them is paid from specified revenue sources.
Income and Revenue Bonds
Income bonds pay no interest unless the issuing company is profitable.
Revenue bonds, so called because the interest on them is paid from specified revenue sources.
Process of issuance and marketing of bonds to the public
Usually takes weeks or even months. First, the issuing company must arrange for underwriters that will help market and sell the bonds. Then, it must obtain the Securities and Exchange Commission’s approval of the bond issue, undergo audits, and issue a prospectus (a document that describes the features of the bond and related financial information). Finally, the company must generally have the bond certificates printed.
Investment community values a bond at
Present value of its expected future cash flows, which consist of (1) interest and (2) principal.
stated, coupon, or nominal rate
Interest rate written in the terms of the bond indenture (and often printed on the bond certificate).The issuer of the bonds sets this rate. The stated rate is expressed as a percentage of the face value of the bonds (also called the par value, principal amount, or maturity value).
Discount & Premium
If the bonds sell for less than face value, they sell at a discount.
If the bonds sell for more than face value, they sell at a premium.
The rate of interest actually earned by the bondholders is called the effective yield or market rate. If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate.
Amortization of a discount increases interest expense. Amortization of a premium decreases interest expense.
Effective-interest Method
Preferred procedure for amortization of a discount or premium.
- Compute bond interest expense first by multiplying the carrying value (book value) of the bonds at the beginning of the period by the effective-interest rate.
- Determine the bond discount or premium amortization next by comparing the bond interest expense with the interest (cash) to be paid.
IFRS Required use of method
GAAP permits the use of the straight-line method if not materially different than the effective-interest method.
Bond Discount
A bond discount means that the company borrowed less than the face or maturity value of the bond. It therefore faces an actual (effective) interest rate higher than the stated (nominal) rate. Conceptually, discount on bonds payable is a liability valuation account (it reduces the face or maturity amount of the related liability). It’s a contra account.
Bond Premium
The lower interest cost results because the proceeds of borrowing exceed the face or maturity amount of the debt. Conceptually, premium on bonds payable is a liability valuation account. It adds to the face or maturity amount of the related liability. It’s an adjunct account.
