Page 612 - Accounting Principles (A Business Perspective)

This book is licensed under a Creative Commons Attribution 3.0 License

Some companies that issued high-interest junk bonds in the 1980s defaulted on their interest payments and had
to declare Chapter 11 bankruptcy or renegotiate payment terms with bondholders in the 1990s. Other companies
with high-interest bonds issued new low-interest bonds and used the proceeds to retire the high-interest bonds.

Chapter 16 discusses the fourth major financial statement—the statement of cash flows, which we mentioned in
Chapter 1. This statement shows the cash inflows and outflows from operating, investing, and financing activities.
Understanding the learning objectives
• A bond is a liability (with a maturity date) that bears interest that is deductible in computing both net

income and taxable income.
• A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible
in determining net income or taxable income.
• Bonds may be secured or unsecured, registered or unregistered, callable, and/or convertible.
• Advantages include stockholders retaining control of the company, tax deductibility of interest, and
possible creation of favorable financial leverage.
• Disadvantages include having to make a fixed interest payment each period, reduction in a company's
ability to withstand a major loss, possible limitations on dividends and future borrowings, and possible

reduction in earnings per share caused by unfavorable financial leverage.
• If bonds are issued at face value on an interest date, no accrued interest is recorded.
• If bonds are issued between interest dates, accrued interest must be recorded.
• If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium
is recorded.
• If the market rate is higher than the contract rate, bonds sell for less than their face value, and a discount is
recorded.

• The present value of the principal plus the present value of the interest payments is equal to the price of the
bond.
• The contract rate of interest is used to determine the amount of future cash interest payments.
• The effective rate of interest is used to discount the future payment of principal and of interest back to the
present value.
• When bonds are issued, Cash is debited, and Bonds Payable is credited. For bonds issued at a discount,
Discount on Bonds Payable is also debited. For bonds issued at a premium, Premium on Bonds Payable is also
credited. For bonds issued between interest dates, Bond Interest Payable is also credited.
• Any premium or discount must be amortized over the period the bonds are outstanding.

• Under the effective interest rate method, interest expense for any period is equal to the effective (market)
rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period.
• Under the straight-line method of amortization, an equal amount of discount or premium is allocated to
each month the bonds are outstanding.
• When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond
redemption may occur.

• A bond sinking fund might be required in the bond indenture.

Accounting Principles: A Business Perspective 613 A Global Text