Bonds

Definition

Bonds are debt securities that represent a loan made by an investor to a borrower, typically a corporation or government. They are used by issuers to raise capital, and in return, bondholders receive periodic interest payments and the return of the bond's face value at maturity. Understanding bonds is crucial for assessing long-term liabilities, computing amortization, and preparing financial statements.

5 Must Know Facts For Your Next Test

1. Bonds can be issued at par, at a premium, or at a discount, depending on how their coupon rate compares to current market rates.
2. Amortization of bonds involves adjusting the book value of the bond over time, reflecting interest expense and changes in carrying value using methods like effective interest.
3. When preparing cash flows using the indirect method, bond transactions may appear in the financing section as cash inflows or outflows related to issuing or redeeming bonds.
4. Bonds can have various features, such as convertibility into stock, callable provisions allowing issuers to repay early, or sinking fund requirements for scheduled repayments.
5. Bond ratings from agencies like Moody's and S&P assess credit risk and can affect the interest rate an issuer must pay to attract investors.

Review Questions

• How does the pricing of bonds influence a company's long-term liabilities on its balance sheet?
  • The pricing of bonds directly affects how long-term liabilities are recorded on a company's balance sheet. When bonds are issued at a premium or discount, it alters the carrying value of the liability over time. A premium results in lower interest expenses recorded in future periods, while a discount increases interest expenses. Understanding these implications is essential for accurately reflecting financial health and obligations.
• In what ways does the effective-interest method differ from other amortization techniques when computing bond expenses?
  • The effective-interest method calculates interest expense based on the carrying amount of the bond at the beginning of each period, resulting in varying interest expenses over time. This contrasts with other methods like straight-line amortization, which spreads the expense evenly across periods. The effective-interest method provides a more accurate representation of financial costs as it aligns with changing market conditions affecting bond pricing.
• Evaluate how bond transactions are reflected in the statement of cash flows when using the indirect method, and why this is significant for financial analysis.
  • When using the indirect method for preparing the statement of cash flows, bond transactions appear in the financing activities section. Issuing bonds is recorded as a cash inflow, while redeeming bonds results in a cash outflow. This is significant because it highlights how financing through debt impacts cash flow management and liquidity. Analyzing these transactions gives insight into a company’s capital structure and its reliance on debt for financing operations.

Related terms

Coupon Rate: The interest rate that the issuer of the bond agrees to pay bondholders, typically expressed as a percentage of the face value.

Face Value: The nominal value of a bond that is repaid to the bondholder at maturity, also known as par value.

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, taking into account both interest payments and any capital gain or loss.