Libby 10e Chap010

chapter 10 Reporting and Interpreting
Bond Securities
Financial Accounting
10e
Libby • Libby • Hodge
Learning Objectives
After studying this chapter, you should be able to:
10-1 Describe the characteristics of bond securities.

10-2 Report bonds payable and interest expense for bond securities
issued at par.
10-3 Compute and analyze the times interest earned ratio.
issued at a discount.
issued at a premium.
10-6 Compute and analyze the debt-to-equity ratio.
10-7 Report the early retirement of bond securities.
10-8 Explain how bond securities are reported on the statement of
cash flows.
Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
10-2
Understanding the Business
A company’s capital structure is the mixture of debt and
equity it uses to finance its operations.
• Borrowing a large amount from an individual bank is often

impractical, so companies and governments issue bond
securities (bonds) to the investing public instead.
• After bonds are issued they are traded on exchanges such

as the New York Bond Exchange.
• The ability to sell a bond is an advantage to investors
because it provides them with liquidity (the ability to
convert investments to cash).
• By issuing more liquid debt that investors can easily
buy and sell in the bond markets, companies are able
to reduce the cost of long-term borrowing.
Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-3
Exhibit 10.1 Excerpts from Amazon’s Long-Term Debt Footnote
Learning Objective 10-1
10-1 Describe the characteristics of bond securities.
10-5
Characteristics of Bonds Payable
Reasons Why Companies Issue Bonds
Advantages
Advantagesofofbonds
bonds Disadvantages
Disadvantagesofofbondsbonds
•• Stockholders
Stockholdersmaintain •• Risk
maintain Riskofofbankruptcy
bankruptcyexists
exists
control because
control because because the bond interest
because the bond interest
bondholders
bondholdersdo donot
notvote
voteoror payments
paymentsmust mustbe bepaid
paid
share in any dividend
share in any dividend each
eachperiod
periodwhether
whetherthe the
payments.
payments. corporation
corporationearns
earnsincome
income
•• AAportion
portionofofinterest
interest or incurs a loss.
or incurs a loss.
expense
expenseisistax
taxdeductible •• Negative
which
deductible Negativeimpact
impacton oncash
cash
which reduces thecost
reduces the costofof flows
flowsbecause
becausebondsbondsmust
must
borrowing. be
borrowing. be repaid at a specifictime
repaid at a specific time
•• The
Thereturn
returntotoshareholders
shareholders ininthe future. Company
the future. Company
can
can be positiveififmoney
be positive moneyisis must
mustbe beable
abletotorepay
repaythethe
borrowed
borrowedatataalow lowinterest
interest debt or refinance
debt or refinance it.it.
rate
rateand
andinvested
investedinin
projects
projectsthat
thatearn
earnaahigher
higher
rate.
rate.
Bond Terminology (1 of 2)
A bond usually requires the payment of interest over its life with
repayment of principal on the maturity date.
The bond principal is:

(1) the amount a company must pay to bondholders at the
maturity date
(2) the amount used to compute the bond’s periodic cash
interest payments.
• Bond principal is also called face value, par value, or
maturity value.
• All bonds have a face value. The face value is usually $1,000,
but it can be any amount.
Bond Terminology (2 of 2)
The coupon rate is the interest rate specified on a bond, and the rate
used to compute the bond’s periodic cash interest payment.
A bond always specifies the coupon rate and the frequency of periodic
cash interest payments.
• The coupon rate is also called the stated rate, contract rate, or
nominal rate.
• The interest payments are sometimes called coupon payments.
• A bond’s coupon rate is always stated in annual terms.
• If interest is paid annually, or once per year, the periodic cash
interest payment is computed as the bond’s face value times its
coupon rate.
• If the interest payment is made more frequently, computing the
cash interest payment requires that the coupon rate be
converted to a rate per interest period before it is multiplied by
the bond’s face value.
Characteristics of different types of bonds
Different types of bonds have different characteristics because
individual investors have different risk and return preferences.
Bond Issuance Process
•• When
Whenaacompany
companydecides
decidestotoissue
issuesecurities
securitiesininthe
thebond
bondmarkets,
markets,ititprepares
preparesaa
bond
bondindenture
indentureandandaabond
bondprospectus.
prospectus.
•• The
Theindenture
indentureisisaalegal
legaldocument
documentthat thatspecifies
specifiesallallthe
thedetails
detailsofofthe
thebond
bond
offering.
offering.
•• The
Theprospectus
prospectusisisaaregulatory
regulatorydocument
documentthat thatisisfiled
filedwith
withthe
theSecurities
Securitiesand
and
Exchange Commission. It also specifies the details of the bond
Exchange Commission. It also specifies the details of the bond offering such offering such
as:
as:
•• Maturity
Maturitydatedate
•• Rate
Rateofofinterest
interesttotobebepaid
paid
•• Date
Dateofofeach
eachinterest
interestpayment
payment
•• Other
Othercharacteristics
characteristicssuch suchasasififthe
thebond
bondisiscallable
callableororconvertible
convertible
•• How
Howthe theproceeds
proceedswillwillbebeused
usedby bythe
thecompany
company
•• The
Theprospectus
prospectusalsoalsocontains
containscovenants
covenantsdesigned
designedtotoprotect
protectthethebondholders
bondholderssuch such
as:
as:
•• limitations
limitationson onnew
newdebt
debtthat
thatthethecompany
companymightmightissue
issueininthe
thefuture
future
•• limitations
limitationson onthe
thepayment
paymentofofdividends
dividendstotoshareholders
shareholders
•• requirements
requirementsthat thatthe
thecompany
companymaintain
maintaincertain
certainminimum
minimumaccounting
accountingratios,
ratios,
such
suchasasthe
thecurrent
currentratio
ratioororthe
thedebt-to-equity
debt-to-equityratio.ratio.
•• When
Whenaabondbondisisissued
issuedtotoananinvestor,
investor,thetheinvestor
investorreceives
receivesaabondbondcertificate.
certificate.
•• An
Anindependent
independentparty,
party,called
calledthe
thetrustee,
trustee,isisusually
usuallyappointed
appointedtotorepresent
representthe the
bondholders.
bondholders.
Bond Rating Agencies and Their Assessments
of Default Risk FINANCIAL ANALYSIS
• Because of the large amount of money involved and
the complexities associated with bonds, several
agencies exist to evaluate the risk that a bond issuer $$$
will not be able to meet the requirements specified in
the prospectus.
• This risk is called default risk. Higher-quality bonds have a lower
default risk, while lower-quality bonds have a higher default risk.
Relationship between Coupon Rate and Market Rate
The bond market determines the price of the bonds by computing the
present value of the bonds using the market rate of interest on the day
the company issues the bonds.
The relationship between the market interest rate and the bond’s
coupon rate determines whether the bond is issued at par, at a
premium, or at a discount.
Bond Contract Market Rate Bond Price
Less than 10% Premium

Coupon rate
is 10% Exactly 10% Par
Greater than 10% Discount
Important: Regardless of whether a bond is issued at par, at a discount,

or at a premium, investors always will earn the market rate of return.
10-12
Bond Information from the Business Press
FINANCIAL ANALYSIS
$$$
Bond prices are reported each day in the business press
based on transactions that have occurred on the bond
exchange.
The above reflects that the Amazon bond pays a coupon rate of 2.5 percent,
will mature in the year 2022, and is currently selling for $94.92. The bond’s
“yield” reflects a return on investment of 3.2 percent for those investors who
purchased the bond at its current price and hold it to maturity.
It is important to remember that the current price listed above does not affect
the bond issuer’s financial statements—the issuer is not a part of the
transaction when one investor decides to sell his or her bond to another
investor.
issued at par.
10-14
Bonds Issued at Par (1 of 5)
10-15
On
OnJanuary
January1,1,2019,
2019,Amazon
Amazonissues
issuesbonds
bondswith
withaacoupon
couponrate
rateofof10
10percent
percent
and
andaaface
facevalue
valueofof$100,000.
$100,000.The
Thebonds
bondsstart
startaccruing
accruinginterest
intereston
onJanuary
January1,1,
2019,
2019,and
andwill
willpay
payinterest
interesteach
eachJune
June3030and
andDecember
December31. 31.The
Thebonds
bonds
mature
matureinintwo
twoyears
yearsononDecember
December31, 31,2020.
2020.
Investors
Investorsare
arewilling
willingto
topay
pay$100,000
$100,000inincash
cashfor
forthe
thebonds
bondsmeaning
meaningthe
the
bonds
bondsare
aresold
soldatatPar.
Par.
10-16
The
Theamount
amountofofmoney
moneyaacompany
companyreceives
receiveswhen
whenititsells
sellsbonds
bondsisisthe
thepresent
present
value
valueof
ofthe
thefuture
futurecash
cashflows
flowsassociated
associatedwith
withthe
thebonds.
bonds.
Amazon agrees to make two types of payments in the future: a single

payment of $100,000 when the bond matures in two years and an annuity of
$5,000 [$100,000 × (10% × ½ year)] payable twice a year for two years. The
10% in the equation is the bond’s coupon rate.
10-17
We use the bond’s market interest rate per period (in this case 10% ÷ 2 =
5%) to compute the bond’s present value as follows:
10-18
•• When
Whenthe themarket
marketrate
rateofofinterest
interestequals
equalsthe
thecoupon
couponrate,
rate,the
thepresent
present
value
valueofofthe
thefuture
futurecash
cashflows
flowsassociated
associatedwith
withaabond
bondalways
alwaysequals
equalsthe
the
bond’s
bond’sface
facevalue
valueamount.
amount.
• • Remember a bond’s selling price is determined by the present value of its
Remember a bond’s selling price is determined by the present value of its
future
futurecash
cashflows,
flows,not
notthe
thefacefacevalue.
value.
On the date Amazon issues the bonds, it records a bond liability equal to the
amount investors are willing to pay for the bonds:
The amount of interest each period will be $5,000 ($100,000 × 0.10 × ½

year). The entry to record each interest payment is as follows:
10-19
Reporting Interest Expense
•• Interest
Interestexpense
expenseisisreported
reportedon onthe
theincome
incomestatement.
statement.Because
Becauseinterest
interestisis
related
relatedto
tofinancing
financingactivities
activitiesrather
ratherthan
thanoperating
operatingactivities,
activities,ititisis
normally
normallynot
notincluded
includedininoperating
operatingexpenses
expensesononthe
theincome
incomestatement.
statement.
• • Interest expense is typically reported just below “income from
Interest expense is typically reported just below “income from
operations”
operations”on onthe
theincome
incomestatement.
statement.
10-20
10-3 Compute and analyze the times interest earned ratio.
10-21
Times Interest Earned
KEY RATIO ANALYSIS
•• This
Thisratio
ratioshows
sufficient
showswhether
whetheraacompany
companyisisgenerating
generating $$$
sufficientresources
resourcesfrom
fromits
itsprofit-making
profit-makingoperations
operations
to
tomeet
meetitsitscurrent
currentinterest
interestobligations.
obligations.
•• AAhigh
highratio
ratioindicates
indicatesan
anextra
extramargin
marginofofprotection
protectioninin
case
caseprofitability
profitabilitydeteriorates.
deteriorates.
•• Failure
Failuretotomeet
meetrequired
requiredinterest
interestpayments
paymentscould
could
result
resultininbankruptcy.
bankruptcy.
issued at a discount.
10-23
Bonds Issued at a Discount (1 of 3)
On
OnJanuary
January1,1,2019,
2019,Amazon
Amazonissues
issuesbonds
bondswith
withaacoupon
couponrate
rateofof10
10percent
percent
and
andaaface
facevalue
valueofof$100,000.
$100,000.The
Thebonds
bondsstart
startaccruing
accruinginterest
intereston
onJanuary
January1,1,
2019,
2019,and
andwill
willpay
payinterest
interesteach
eachJune
June3030and
andDecember
December31. 31.The
Thebonds
bonds
mature
matureinintwo
twoyears
yearsononDecember
2020.
The
Thecoupon
couponrate
rate(10
(10percent)
percent)isisless
lessthan
thanthe
themarket
marketinterest
interestrate
rate(12
(12
percent)
percent)on
onthe
thedate
dateofofissuance
issuancesosothe
thebonds
bondssell
sellatataadiscount.
discount.
To
Tocompute
computewhatwhatinvestors
investorswill
willbe
bewilling
willingto
topay
payfor
forthe
thebonds
bondsgiven
giventhe
the
difference
differenceinininterest
interestrates,
rates,we
wecan
cancalculate
calculatethe
thecash
cashissue
issueprice
priceusing
usingthe
the
tables
tablesininAppendix
AppendixE:E:
10-25
There are two acceptable methods for recording a bond that is sold at
a discount:
• Explicitly keep track of the bond discount by incorporating it into
the journal entries
• Implicitly keep track of the bond discount but do not incorporate it
into the journal entries.
Regardless of the method used, the dollar value reported on the
balance sheet (the bond payable book value) is identical.
The journal entries to record the sale of Amazon’s bonds issued at a

discount are:
Bond
Bonddiscount
discountisisaa
contra-liability
contra-liabilityaccount
account
Reporting Interest Expense on Bonds Issued at a Discount
Using Effective-Interest Amortization (with Discount Account)
(1 of 3)
Under the effective-interest amortization method, a company computes
interest expense in a given period by multiplying the bonds payable book
value times the market rate of interest on the date of issuance.
(2 of 3)
The cash owed for interest is computed by multiplying the bond’s face value
($100,000) by the coupon rate per period (10% × ½ year).
Thus, Amazon owes bondholders cash of $5,000 each June 30 and again on
December 31. The first interest payment on the bonds is made on June 30,
2019.
The journal entry at June 30, 2019 is:
(3 of 3)
Interest expense for the next interest period must reflect the change in the
bonds payable book value.
Interest expense for the second half of 2019 is calculated as follows:

Multiply the bonds payable book value on June 30, 2019 ($97,327) by
the market rate of interest per period:
$97,327 × (12% × ½ year) = $5,840
With interest expense equal to $5,840 and cash owed for interest equal
to $5,000, the amount of the bond discount amortized on December
31, 2019, is $840.
The journal entry at December 31, 2019 is:
Bond Discount Amortization Schedule
issued at a premium.
10-31
Bonds Issued at a Premium (1 of 3)
On
OnJanuary
January1,1,2019,
2019,Amazon
Amazonissues
issuesbonds
bondswith
withaacoupon
couponrate
rateofof10
10percent
percent
and
andaaface
facevalue
valueofof$100,000.
$100,000.The
Thebonds
bondsstart
startaccruing
accruinginterest
intereston
onJanuary
January1,1,
2019,
2019,and
andwill
willpay
payinterest
interesteach
eachJune
June3030and
andDecember
December31. 31.The
Thebonds
bonds
mature
matureinintwo
twoyears
yearsononDecember
2020.
The
Thecoupon
couponrate
rate(10
(10percent)
percent)isismore
morethan
thanthe
themarket
marketinterest
interestrate
rate(8(8
percent)
percent)on
onthe
thedate
dateofofissuance
issuanceso
sothe
thebonds
bondssell
sellatataapremium.
premium.
To
Tocompute
computewhatwhatinvestors
investorswill
willbe
bewilling
willingto
topay
payfor
forthe
thebonds
bondsgiven
giventhe
the
difference
differenceinininterest
interestrates
ratescalculate
calculatethe
thecash
cashissue
issueprice
priceusing
usingthe
thetables
tablesinin
Appendix
AppendixE:E:
10-33
Accounting for bonds issued at a premium is similar to accounting for
bonds issued at a discount.
Companies can explicitly use a bond premium account in their journal
entries or implicitly keep track of the premium amount.
The journal entries to record the sale of Amazon’s bonds issued at a

premium are:
Bond
Bondpremium
premiumisis
sometimes
sometimescalled
calledan
an
adjunct-liability
adjunct-liabilityaccount
account
Reporting Interest Expense on Bonds Issued at a Premium
Using Effective-Interest Amortization (with Premium Account)
(1 of 2)
Under the effective-interest amortization method, a company computes
interest expense in a given period by multiplying the bonds payable book
value times the market rate of interest on the date of issuance.
Reporting Interest Expense on Bonds Issued at a Premium
Using Effective-Interest Amortization (with Premium Account)
(2 of 2)
The cash owed for interest is computed by multiplying the bond’s face value
($100,000) by the coupon rate per period (10% × ½ year).
Thus, Amazon owes bondholders cash of $5,000 each June 30 and again on
December 31. The first interest payment on the bonds is made on June 30,
2019.
The journal entry at June 30, 2019 is:
Bond Premium Amortization Schedule
Journal Entry to Retire the Bonds at Maturity
Regardless of whether a company issues bonds at par, at a

discount, or at a premium, the company will enter the same
journal entry when it retires the bonds at maturity.
For our Amazon example, the journal entry would be
Exhibit 10.2
The Book Value of a Bond Over Time
Zero Coupon Bonds
FINANCIAL ANALYSIS
Zero coupon bonds do not pay periodic cash interest.

Investors will price the bond so that they earn the
market rate of interest.
$$$
Because
Becausethere
thereisisno
noperiodic
periodiccash
cashpaid
paidfor
forinterest:
interest:
PV
PVofofthe
thePrincipal
Principal==Issue
IssuePrice
Priceofofthe
theBonds
Bonds
Zero
Zerocoupon
couponbonds
bondsarearealways
alwaysissued
issuedatataadeep
deepdiscount
discount(substantially
(substantially
less
lessthan
thanmaturity
maturityvalue).
value).
Accounting
Accountingfor
foraazero
zerocoupon
couponbond
bondisisno
nodifferent
differentthan
thanaccounting
accountingfor
for
other
otherbonds
bondsissued
issuedatataadiscount.
discount.
However,
However,the
theamount
amountofofthe
thediscount
discountisismuch
muchlarger.
larger.
Reporting Interest Expense Using Straight-Line Amortization
GAAP requires that companies use the effective-interest method to
amortize bond discounts and bond premiums.
GAAP permits companies to use straight-line amortization when

results do not materially differ from results computed using the
effective-interest method. With straight-line amortization, a
company simply takes the total amount of the discount or the
premium at issuance, divides it by the number of periods in the
bond’s life, and amortizes that amount each period.
The straight-line amortization schedule for Amazon would reflect the following:
10-6 Compute and analyze the debt-to-equity ratio.
10-42
Debt-to-Equity
KEY RATIO ANALYSIS
$$$
This
Thisratio
ratioshows
showsthe
therelationship
relationshipbetween
betweenthe
theamount
amountofofcapital
capital
provided by owners and the amount provided by creditors.
provided by owners and the amount provided by creditors.
InIngeneral,
general,aahigh
highratio
ratioindicates
indicatesthat
thataacompany
companyrelies
reliesheavily
heavilyon
on
debt
debtfinancing
financingrelative
relativeto
toequity
equityfinancing.
financing.This
Thisincreases
increasesthe
therisk
risk
that
thataacompany
companymaymaynotnotbe
beable
abletotomeet
meetits
itscontractual
contractualfinancial
financial
obligations
obligationsduring
duringaabusiness
businessdownturn.
downturn.
10-7 Report the early retirement of bond securities.
10-44
Early Retirement of Bonds
Some
Somebonds
bondshavehaveaacall
callfeature
featurethat
thatallows
allowsthe
theissuing
issuingcompany
companyto tocall
call
(retire) the bonds early. A call feature most often requires the issuing
(retire) the bonds early. A call feature most often requires the issuing
company
companyto topay
payinvestors
investorsananamount
amountgreater
greaterthan
thanthe
thebond’s
bond’sface
face
value
valuetotoretire
retirethe
thebonds
bondsbefore
beforetheir
theirmaturity
maturitydate.
date.The
Theamount
amount
often
oftenisisstated
statedasasaapercentage
percentageofofthethebond’s
bond’sface
facevalue.
value.
Book Value > Book Value <

Cash Paid to Cash Paid to
Retire Bonds = Retire Bonds =
GAIN LOSS
In some cases, a company may elect to retire bonds early by purchasing

them on the open market, just as an investor would.
Price of Bonds versus Market Interest Rates
Bond
Bondprices
pricesmove
moveininthe
theopposite
oppositedirection
directionofofinterest
interestrates.
rates.
IfIfinterest
interestrates
ratesgo
goup,
up,bond
bondprices
pricesfall,
fall,and
andvice
viceversa.
versa.
If interest rates go up enough, a company may decide that it makes good

economic sense to retire its bonds early by purchasing them on the
open market.
10-8 Explain how bond securities are reported on the statement of
cash flows.
10-47
Bonds Payable
FOCUS ON CASH FLOWS
$$$
Payment of interest under U.S. GAAP is an operating cash outflow.

Interest expense is reported on the income statement and is a
component of net income. As a result, GAAP requires that interest
payments be reported as operating activities on the statement of cash
flows.
Chapter Supplement: Accounting for Bonds without a
Discount Account or Premium Account
For financial reporting purposes, it is not necessary to use a
discount (or premium) account when recording the sale of bonds.
The journal entries to record the sale of bonds issued at a discount are:
The journal entry to record interest expense, without the discount account:

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Libby 10e Chap010

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chapter 10 Reporting and Interpreting

10-1 Describe the characteristics of bond securities.

• Borrowing a large amount from an individual bank is often

• After bonds are issued they are traded on exchanges such

The bond principal is:

Bond Contract Market Rate Bond Price

Less than 10% Premium

Greater than 10% Discount

Important: Regardless of whether a bond is issued at par, at a discount,

Amazon agrees to make two types of payments in the future: a single

The amount of interest each period will be $5,000 ($100,000 × 0.10 × ½

The journal entries to record the sale of Amazon’s bonds issued at a

The journal entry at June 30, 2019 is:

Interest expense for the second half of 2019 is calculated as follows:

The journal entry at December 31, 2019 is:

The journal entries to record the sale of Amazon’s bonds issued at a

The journal entry at June 30, 2019 is:

Regardless of whether a company issues bonds at par, at a

For our Amazon example, the journal entry would be

Zero coupon bonds do not pay periodic cash interest.

GAAP permits companies to use straight-line amortization when

Book Value > Book Value <

In some cases, a company may elect to retire bonds early by purchasing

If interest rates go up enough, a company may decide that it makes good

Payment of interest under U.S. GAAP is an operating cash outflow.

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