INTRODUCTION:
Bonds are a long-term liability. Companies sell bonds as a method of
borrowing a large amount of money for a long period of time (up to 100
years as in the case of Disney). Bonds have a set maturity date when they
are due and a set rate of interest and interest payment dates.
BOND FUNDAMENTALS:
The bond example I am using throughout the lecture on this chapter
is an issue of 100 $1,000 bonds. The $1,000 is called the face amount of
the bond and represents the amount that the company will pay out when the
bonds come due or mature.
The interest rate on the bond is 8%. This is called the contract or
stated rate. This rate multiplied by the face amount determines the interest
to be paid to the bondholders. Our bonds, like most in the real world,
pay interest on a semi-annual basis. Therefore the interest to be paid
every June 30 and December 31 over the life of the bonds is $100,000 x
8% x 6/12 = $4,000. For the sake of ease in explanation, our bonds will
be issued on January 1, 2002 and mature on December 31, 2003. This is a
two year life, therefore, there will be a total of four interest payments.
JOURNAL ENTRIES:
In this first example we are assuming the bonds were sold "at par"
or at their face amount of $100,000.
On January 1, 2002, the date of issue, the following journal entry
will be recorded:
DR - Cash 100,000
CR - Bonds Payable 100,000
On each June 30 and December 31 the following journal entry is appropriate:
DR - Bond Interest Expense 4,000
CR - Cash 4,000
This entry will be made four times, therefore the total amount of interest
expense to be recognized over the life of the bonds is $16,000 (4 x $4,000).
On December 31, 2003, the maturity date of the bonds, the company must
buy back the bonds to pay off their debt. The amount due is the face amount
or $100,000.
DR - Bonds Payable 100,000
CR - Cash 100,000
CASH PAYOUT and CASH PROCEEDS:
An important concept to remember regarding bonds is the cash payout.
This is the total amount of cash to be paid out by the company to the bondholders
over the life of the bonds. It consists of two things, the interest payments
and the face amount. For our bond that would be $100,000 + $16,000 = $116,000.
The cash proceeds is the amount of cash received by the company when the bonds are issued. For our bonds, issued at par, that is $100,000.
*** The difference between the cash payout and the cash proceeds is the interest expense to be recognized by the company over the life of the bonds. ***
For our bond issue the following applies:
Cash Payout = $116,000
Cash proceeds = $100,000
Interest Expense = $16,000
Note: If you refer back to the interest payment entries, you will see that at each interest payment date, the debit to interest expense was $4,000. This entry was made 4 times. Four times $4,000 = $16,000, the interest expense amount for our bond issue.
SELLING PRICE:
What happens when the bonds do not sell at par or at their face amount,
why would this occur?
Selling price of a bond issue will vary depending on what happens to
the interest rate that is available to investors on similar risk securites
(this is called the market rate).
If an investor can find a similar risk investment that is paying a
higher return than ours at 8%, we will have to lower the price in order
to sell the bonds. When this happens, the bonds sell at a discount. This
means our cash proceeds are less, therefore our interest expense is more,
and the bondholder earns a higher effective rate, comparable to the market
rate.
In the opposite case, when the market rate on similar risk investments is lower, we can charge a higher price for our bonds, a premium. The cash proceeds will be higher and the interest expense will be lower. The bondholder will earn an effective rate that is lower, comparable to the market rate.
***Bond selling price DOES NOT effect the cash payout!!***
The cash proceeds will increase or decrease based on the change in selling price, but the amount the company pays out over the life of the bond (based on the face amount and the contract rate that are printed on the bond) does not, this causes the interest expense to fluctuate.
***The market rate of interest and the bond selling price have an inverse or opposite relationship***
When the market rate goes up, the selling price goes down. When the market rate goes down, the selling price goes up.
BOND PRICE QUOTES:
Bond prices are quoted not as dollars but as a percentage of the face
amount. Bondholders are most interested in whether a bond is selling above
or below the face amount (premium or discount). If a bond is quoted at
97, it means the bond is selling at a discount, 97% of the face amount.
A bond with a face amount of $500 selling at 97 would bring $485.
BONDS SELLING AT A DISCOUNT:
Market rate goes up, bonds prices go down...... discount.
Assume our bond issue with a face amount of $100,000 sells at 99. This
means the selling price and the cash proceeds would be $99,000. The journal
entry to record the bond issue would be:
DR - Cash $99,000
DR - Discount $1,000
CR - Bonds Payable $100,000
The credit to bonds payable represents the amount that has to be paid
when the bonds mature, the face amount. This credit is always for the face
amount.
In this situation the cash payout (always the same) is $116,000, the
cash proceeds are $99,000, so the interest expense is $17,000. That is
$1,000 more than it was when we sold the bonds at par.
***Discount increases interest expense.***
On each interest payment date, the discount will be amortized or written off. This increases the amount that is recognized as interest expense each time -- eventhough the cash paid out for interest is the same. One way to do this is to use the straight-line method. The discount amount is divided by the number of interest periods: $1,000/4 = $250. Each interest payment date, the discount will be reduced by $250 and the interest expense will increase by $250.
The journal entry in this situation to record the interest expense and
interest payment would be:
DR - Interest Expense $4,250
CR - Discount $250
CR - Cash $4,000
The debit to interest expense for $4,250 will be made four times for a total of $17,000. This agrees with the difference between the cash payout and the cash proceeds of $17,000.
CARRYING VALUE:
The presentation of the liability on the balance sheet is called the
carrying value or book value. In the case of a discount, the Bond Carrying
Value is equal to the balance in the Bonds Payable account (face amount)
minus the balance of the discount.
Over the life of the bonds, the following table will apply:
| Date | Bonds Payable | Discount | Carrying Value |
| 1-1-2002 | $100,000 | $1,000 | $99,000 |
| 6-30-2002 | $100,000 | $750 | $99,250 |
| 12-31-2002 | $100,000 | $500 | $99,500 |
| 6-30-2003 | $100,000 | $250 | $99,750 |
| 12-31-2003 | $100,000 | $0 | $100,000 |
At the issue date, the bond carrying value is equal to the issue or
selling price.
At maturity, the carrying value is equal to the face amount.
The carrying value for a bond sold at a discount will initially be an amount below face amount and gradually increase to face amount.
BONDS SELLING AT A PREMIUM:
Market rate goes down, selling price goes up......premium.
Our bond issue sells at 102 = 102% of the face amount = $102,000 = cash proceeds. The bond interest expense is found by subtracting the cash proceeds of $102,000 from the cash payout of $116,000 = $14,000.
***Selling bonds at a premium reduces interest expense***
The journal entry to record the bond issue will be:
DR - Cash 102,000
CR - Premium 2,000
CR - Bonds Payable 100,000
When the interest payment is made, the premium is amortized. This reduces
the amount that is recognized as interest expense each time - eventhough
the cash paid out for interest is the same.
The straight-line method is used to calculate the amount of premium
that is amortized: $2,000/4 = $500 each time for four interest payments.
The journal entry is:
DR - Interest Expense $3,500
DR - Premium $500
CR - Cash $4,000
The debit to interest expense of $3,500 times four interest payments equals $14,000 which is the same as the difference between the cash proceeds and the cash payout for this bond issue.
CARRYING VALUE:
The carrying value for a bond issued at a premium is calculated by
adding together the face amount and the premium. At issue, the carrying
value is the same as the selling price: $100,000 + $2,000 = $102,000. The
chart below shows how the carrying value decreases each interest payment
and amortization until it equals the face amount at maturity:
| Date | Bonds Payable | Premium | Carrying Value |
| 1-1-2002 | $100,000 | $2,000 | $102,000 |
| 6-30-2002 | $100,000 | $1,500 | $101,500 |
| 12-31-2002 | $100,000 | $1,000 | $101,000 |
| 6-30-2003 | $100,000 | $500 | $100,500 |
| 12-31-2003 | $100,000 | $0 | $100,000 |
USING PRESENT VALUE IN BOND SELLING PRICE CALCULATIONS:
When the market interest rate changes, bond selling prices change accordingly.
The exact amount of discount or premium is based on the rate of return
the bondholder is seeking. The selling price of a bond issue is usually
determined by calculating what amount should be invested to earn a specific
rate of return. This can be done because the future payments (the cash
payout) do not change, regardless of the selling price. The selling price
can be determined by eliminating the interest component from the future
payments (the interest payments of $4,000 and the face amount of $100,000).
To do this we can use present value tables or a financial calculator. Both
these methods are math shortcuts to deduct the interest from the future
value of an amount of money and determine its present value.
Our textbook provides present value tables. Use the present value of
a single sum table for the face amount, and the present value of an annuity
table for the interest payments. An annuity is a series of equal payments
at regular intervals. This describes our interest payments.
To use the tables, we need a value for "n" and "i". The "n" is determined
by the number of interest periods. The "i" is determined by the interest
rate that is effective (the rate dictated by the market).
DISCOUNT:
Assume the market rate increases to 10%. The bondholders will pay a
price for the bonds that reflects that rate of return to them. To determine
the selling price we need to calculate the present value of the interest
payments and face amount at an effective rate of 10% (5% on a semi-annual
basis). To use the tables, our n=4 and i = 5%.
The selling price would be determined as follows:
Face amount x PV factor from table 2 at n=4, i=5% =
$100,000 x 0.8227 = $82,270
plus
Interest payment x PV factor from table 4 at n=4, i=5% =
$4,000 x 3.5460 = $14,184.
Then add these two amounts together: $82,270 + $14,184 = $96,454. This
is the selling price that will earn the investor an effective rate of 10%
even though the stated rate on the bond is 8%.
The bond is selling at a discount, so the price is below the face amount.
The bondholders will pay out $96,454 and receive the $4,000 interest
payments and the $100,000 face amount. They will earn an effective rate
of 10% on their money. The bond issue will cost the company an amount equal
to 10% on their debt.
To use a financial calculator, enter 4 for n, 5% for i, $100,000 for FV, $4000 for PMT and solve for PV -- $96,454.05.
PREMIUM:
Market rate goes down to 6%. The bond selling price is calculated using
the same tables and n=4, but a different i of 3% which is half the effective
rate of 6%:
Face amount x PV factor from table 2 at n=4, i=3% =
$100,000 x 0.8885 = $88,850
plus
Interest payment x PV factor from table 4 at n=4, i=3% =
$4,000 x 3.7171 = $14,868.
Adding these two amounts together, we get $88,850 + 14,868 = $103,718.
To use a financial calculator, enter 4 for n, 3% for i, $100,000 for
FV, $4,000 for PMT and solve for PV. You should get $103,717.10.
The bondholders paid $103,718 for the bonds and will receive the $4,000
interest payments and $100,000 when the bonds mature. This represents an
effective return to the bondholders of 6% even though the stated rate on
the bond is 8%.
The bond is selling at a premium, so the selling price is above the face amount.
AMORTIZATION USING THE EFFECTIVE INTEREST METHOD:
The effective interest method of amortizing premium or discount on bonds is more accurate. Instead of the same amount of interest expense being recorded on each interest payment date, the amount of interest expense varies, based on the carrying value of the bonds. The interest expense is calculated by multiplying the carrying value by the market or effective rate by one-half. The difference between the interest expense amount and the interest payment amount is the amortization of the discount or premium.
PREMIUM:
The amortization table for a bond sold at a premium, using the selling
price of the bond issue we calculated earlier using 6% as the market rate,
is given below. The same general rules apply. The original
carrying value is the same as the selling price and the carrying value
at maturity is equal to the face amount of the bonds. The ending
balance in the premium account must be zero.
| Date | Interest Payment
(4% x face amount) |
Interest Expense
(3% x CV) |
Amor of Prem
(paymnt - expense) |
Premium balance | Carrying Value (face amt + prem) |
| 1-1-2002 | 3718 | 103,718 | |||
| 6-30-2002 | 4000 | 3112 | 888 | 2830 | 102,830 |
| 12-31-2002 | 4000 | 3085 | 915 | 1915 | 101,915 |
| 6-30-2003 | 4000 | 3057 | 943 | 972 | 100,972 |
| 12-31-2003 | 4000 | 3028** | 972* | 0 | 100,000 |
*This number is fudged to make the premium balance come out to zero.
** This number is obtained by subtracting 4000 - 972 = 3028.
The journal entry to record the interst expense for 6-30-2002 would
be:
DR Bond interest expense 3112
DR Premium
888
CR Cash
4000
DISCOUNT
An amortization table for a bond sold at a discount, using the
10% market rate and $96,454 selling price from earlier is given below.
| Date | Interest Payment
(4% x face amount) |
Interest Expense
(5% x CV) |
Amor of Discount
(Int exp - payment) |
Discount Balance
(reduced by amor) |
Carrying Value
(face amt - disc) |
| 1-1-2002 | 3546 | 96,454 | |||
| 6-30-2002 | 4000 | 4823 | 823 | 2723 | 97,277 |
| 12-31-2002 | 4000 | 4864 | 864 | 1859 | 98,141 |
| 6-30-2003 | 4000 | 4907 | 907 | 952 | 99,048 |
| 12-31-2003 | 4000 | 4952 | 952* | 0 | 100,000 |
The journal entry required on 6-30-2002 would be:
DR Bond interest expense 4823
CR Discount
823
CR Cash
4000