Page 613 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

• Bonds may be convertible into shares of stock. The carrying value of the bonds is the capital contributed for
shares of stock issued.

• Bonds are rated as to their riskiness.
• The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation.
• Each of these services has its own rating scale. For instance, the highest rating is Aaa (Moody's) and AAA
(Standard & Poor's).
• The times interest earned ratio indicates a company's ability to meet interest payments when due.
• The ratio is equal to income before interest and taxes (IBIT) divided by interest expense.
• The future value of an investment is the amount to which a sum of money invested today will grow in a

stated time period at a specified interest rate.
• Present value is the current worth of a future cash receipt and is the reciprocal of future value. To discount
future receipts is to bring them back to their present values.
Appendix: Future value and present value

Managers apply the concepts of interest, future value, and present value in making business decisions.
Therefore, accountants need to understand these concepts to properly record certain business transactions.
The time value of money

The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at
any future date. Most individuals prefer having a dollar today rather than at some future date because (1) the risk
exists that the future dollar will never be received; and (2) if the dollar is on hand now, it can be invested, resulting
in an increase in total dollars possessed at that future date.
Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision
making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be
accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value,

before comparisons are valid. Such comparisons involve future value and present value concepts.
Future value

The future value or worth of any investment is the amount to which a sum of money invested today grows
during a stated period of time at a specified interest rate. The interest involved may be simple interest or compound
interest. Simple interest is interest on principal only. For example, USD 1,000 invested today for two years at 12
per cent simple interest grows to USD 1,240 since interest is USD 120 per year. The principal of USD 1,000, plus 2
X USD 120, is equal to USD 1,240. Compound interest is interest on principal and on interest of prior periods.
For example, USD 1,000 invested for two years at 12 per cent compounded annually grows to USD 1,254.40 as
follows:
Principal or present value $1,000.00
Interest, year 1 = $1,000 x 0.12 = 120.00
Value at end of year 1 $1,120.00
Interest, year 2 = $1,120 x 0.12 = 134.40
Value at end of year 2 (future value) $1,254.40
In Exhibit 122, we graphically portray these computations of future worth and show how USD 1,000 grows to
USD 1,254.40 with a 12 per cent interest rate compounded annually. The effect of compounding is USD 14.40—the
interest in the second year that was based on the interest computed for the first year, or USD 120 X 0.12 = USD

14.40.

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