311-Ch10RevNotes(7th) - Chapter 10 - Reporting and...

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Overview This chapter discusses bonds payable, which represent a primary way for corporations to obtain funds to acquire long-term assets and to expand a business. An important advantage of bonds payable is that the cost of borrowing the funds - interest expense - is deductible on the income statement (and for income tax purposes) which reduces the interest cost to the business. Bonds may be sold at their par amount, at a premium, or at a discount, depending on the stated interest rate on the bonds compared with the market rate of interest. In each case, bonds are recorded at the present value of their future cash flows. The issue price of a bond varies based on the relationship between the market rate and stated rate of interest. If the stated rate is higher than the market rate on the bond, the bonds will sell at a premium. Conversely, if the stated rate is lower than the market rate on the bond, the bonds will sell at a discount. If the stated rate and the market rate on the bonds are the same, the bonds will sell at par. Discounts and premiums on bonds payable are adjustments to interest expense for the issuing company during the term of the bonds. Therefore, the discount or premium on bonds payable is amortized over the period outstanding from issue date to maturity date. Business Background The capital structure of a company is a mixture of debt and equity. Corporations frequently raise debt capital by borrowing money through the issuance of bonds. Bonds are securities issued by corporations as well as government entities. Because of established markets, a bondholder may sell the bond before its maturity date to another investor on the bond exchange. This provides the bondholder with liquidity since he can convert his investment to cash at any time. There are advantages for corporations that issue bonds. Ownership and control are not diluted by issuing bonds. Dilution would take place if additional stock were issued instead. Interest is tax deductible whereas dividends are not. Net interest cost is interest cost less any income tax savings associated with interest expense. The liquidity of bond investments typically permits corporations to reduce the cost of long-term borrowing. This can give rise to positive financial leverage (borrowing at one rate and investing at a higher rate). There are also disadvantages associated with the issuance of bonds. Required interest payments must be made each interest period. If payments are not made, there is a risk of bankruptcy. The principal (par) of the bond must be paid at the maturity date. This is so even if the corporation has no earnings. On the other hand, dividends to stockholders usually materialize only if the company has earnings (or retained earnings). Chapter 10 Review Notes
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311-Ch10RevNotes(7th) - Chapter 10 - Reporting and...

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