Accounting Class 8
Q. A $3,000,000 issue of 10-year, 9% bonds was sold at 98 plus accrued interest three months after the bonds were dated. What net amount of cash is received?
A. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500
Valuations of Bonds
Investors value a bond at the present value of its expected future cash flows, which consist of (1) interest, and (2) principal. Between the time the company sets the terms and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly. Such changes affect the marketability of the bonds and thus their selling price.
Example Journal Entry when Nonimal > Market
Journal Entries On Issue Date Dr Cash 105,646 Cr Premium on Bonds Payable 5,346 Bonds Payable 100,000
Example journal entry when nominal < Market
Journal Entries On Issue Date Dr Cash 95,027 Discount on Bonds Payable 4,973 Cr Bonds Payable 100,000
Show Journal Entry for a bond when nominal = market
Journal Entries On Issue Date Debit Cash 95,027 Discount on Bonds Payable 4,973 Credit Bonds Payable 100,000
What is Bonds Payable
Contract that represents a promise to pay: A) a sum of money at designated maturity date, plus periodic interest at a specified rate on the maturity amount B) Paper certificate, typically a $1,000 face value: Issued to numerous investors C) Purpose is to borrow from numerous lenders when the amount of capital needed is too large for one lender to supply
Show Example Journal Entry for Amortization of Bond Discount (nominal < market
Cr. Interest Exp 9503 Dr Cash 8000 Dr Discount on Bond 1503
Show Example Journal Entry for Amortization of Bond Discount (nominal > market
Dr. nterest Expense 6,321 Cr Premium on Bond 1,679 Cr Cash 8,000
Provide examples of other Long-Term liabitlies that similar to bonds
Examples of other long-term liabilities that are valued similar to the way we value bonds. That is, they are valued based on the present value of expected future cash outflows: Notes payable, Mortgage, Pension Liabilites, Lease obligations, Asset retirement obligations
How is interest rate determined for Bond
Interest rate is based on: 1) Prevailing interest rates at time of issue 2) Credit rating of issuing company 3) Other features of the bond (call or convertible features
Explain Acct for Extinguishment of Debt
If bonds are held to maturity, then there is no gain or loss when the bonds are paid off Dr. Bonds Payable 100,000 Cr. Cash 100,000 If bonds are extinguished before maturity, then there may be a gain or loss on extinguishment - A company will have to pay current market rates to extinguish a bond prior to maturity - If the market interest rate has changed since the issuance date, then the market value of the bonds will have changed
Q. Why do companies report a gain or loss on the repurchase of their bonds (assuming the repurchase price is different form bond book value)?
A. Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become "realized." If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss).
Q. How should premium or discount non-bonds payable be presented on the balance sheet?
A. Bonds payable is presented in the balance sheet net of any discount or plus any premium
Q. How does issuing a bond at a premium or discount affect the bond's effective interest rate via-a-vis the coupon (stated) rate?
A. Bonds sold at face (par) value earn an effective interest rate equal to the bonds' coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.
Q. What is the difference between a bond couple rate and its market interest rate (yield)
A. The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond's market rate and the bond's market price.
Q. Regardless of whether premium or discount is involved, what generalization can be made about the change in the book value of bonds payable during the period in which they are outstanding?
A. When the bonds mature, the book value of the bonds will be equal to the face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued.
Q. If the effective interest amortization method is used for bonds payable, how does the periodic interest expense change over the life of the bonds when they are issued (a) at a discount and (b) at a premium?
A. When the effective interest method is used to amortize a bond discount or premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases.
How are Bonds Payable Accounted For?
At time of issuance, bonds are recorded at fair value: This results in either a discount or premium if the market rate of interest is different from the stated (nominal) rate After issuance, the bond is accounted for at amortized cost 1) The premium or discount is amortized as part of interest expense 2) Companies do have an option to account for the bond at fair value over the life of the bond When a bond is extinguished before maturity, a gain or loss is recorded in the income statement
Explain how discount/Premium is reported on Balance Sheet
Bonds payable are reported net of any discount or premium & Discount/premium is a liability valuation account Amortizing the discount or premium • A premium or discount is considered an adjustment to the nominal interest rate so that it reflects the actual market rate • The preferred method of amortizing the discount/premium is called the effective-interest method
Explain how to account for the following :Three year 8% bonds of $100,000 issued on Jan. 1, 2017, are recalled at 105 on Jan. 1, 2019. Expenses of recall are $2,000. Market interest on issue date was 10%.
Journal Entry Jan 1, 2019 Dr. Bonds Payable 100,000 Dr. Loss on Extinguishment of Bond ** 8,817 (From 5,000 recall + 2000 charge + 1,817 Cr. Cash 107,000 Cr., Discount on Bond 1,817 ** This line is an expense on income statement
What are Long Term Liabilities provide examples
Long-term liabilities consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Debt refers to amounts owed related to borrowings Examples: Bonds, Notes payable, Mortgages, Other long-term liabilities: Leases, Pension and other retirement plans. Deferred taxes we will not cover these
Explain the types of Interest Rates for Bonds
Stated, coupon, or nominal rate: the interest rate written in the terms of the bond indenture. This rate determines the actual cash interest payments made by the corporation Market rate or effective yield: rate that provides an acceptable return on an investment commensurate with the issuer's risk characteristics.This is the rate of interest actually earned by the bondholders.
Explain Fair value option related to financial Assets and Liabilities
US GAAP allows companies the option to value most financial assets and liabilities at fair value • This is referred to as the fair value option and • When a company chooses to value a bond liability at fair value: 1) the bonds are reported at fair value in the balance sheet 2) any change in value from one period to the next is reported as an unrealized gain (loss) in the income statement
