Bond Accounting Principles

Types of bonds -- There are several classifications of bond issues. The most important for the exam are:

1. Secured vs. unsecured (debentures) 2. Serial vs. single maturity term 3. Callable vs. redeemable 4. Convertible vs. nonconvertible

1. Stated Rate > Market Rate

1. Stated Rate > Market Rate -- If the stated interest rate is greater than the market rate of interest, the bonds will sell at a premium. (Premium: stated rate > market rate) a. The premium -- Is the amount received above face value and is recorded in Premium on Bonds Payable, an adjunct account to Bonds Payable. If a $1,000 bond sells for $1,100, then the premium is $100. The bond sells at a premium because the bond is paying a higher stated rate than required on the market. The price increases (and yield rate decreases) to the point at which the yield rate equals the market rate for similar bonds. The more a bondholder pays for a bond, the lower the yield rate.

2. Stated Rate < Market Rate

2. Stated Rate < Market Rate -- If the stated interest rate is less than the market rate of interest, the bonds will sell at a discount (Discount: stated rate < market rate). a. The discount -- Is the amount below face value and is recorded in Discount on Bonds Payable, a contra account to Bonds Payable. If a $1,000 bond sells for $950, then the discount is $50. The bond sells at a discount because the bond is paying a lower stated rate than required on the market. The price decreases (and yield rate increases) to the point at which the yield rate equals the market rate for similar bonds. The less a bondholder pays for a bond, the higher the yield rate. Discounts are more common than premiums.

Amortization of Premium / Discounts - Effective Interest Rate method

3. Effective interest method -- This method first computes interest expense based on the beginning book value of the bond and the market rate at issuance. The difference between interest expense and the cash interest paid is the amortization of the discount or the premium. The market rate at issuance is always used. The rate is not changed after issuance because it represents the true interest rate over the bond term. The amortization of discount or premium is a "plug" figure.

3. Stated Rate Equals Market Rate

3. Stated Rate Equals Market Rate -- If the stated rate and market rate are equal, the bond sells at face value and no premium or discount is recorded. (Sell at face value: stated rate = market rate)

Amortization of Premium / Discounts --

Amortization of Premium / Discounts -- 1. The discount or premium on a bond issue is amortized over the bond term. The book value of the bond issue must equal face value on the maturity date because that is the amount paid to retire the bonds. 2. The amortization of premiums and discounts is accomplished through the use of the effective interest method. Due to materiality, many companies employ the straight-line amortization method. The straight-line method is acceptable only if the results do not depart materially from the effective interest method. Note: Both methods of amortization are tested on the exam. Questions with more involved requirements often use the straight-line method because the amounts are easier to compute.

Amortize Discount

B. Amortize Discount -- 1. When a discount is amortized, the bond interest expense is adjusted upward to reflect the higher market rate of interest. An example entry is: Interest Expense xx Discount on Bond xx Cash xx 2. Interest expense exceeds cash interest because the firm received an amount less than face value but will pay back face value. The total interest cost to the firm over the bond term is the total cash interest paid plus the total discount.

Bond

Bond : A bond is a financial debt instrument that typically calls for the payment of periodic interest (although a zero coupon bond pays no interest), with the principal being due at some time in the future. The bondholder (creditor or investor) pays the issuing firm an amount based on the stated and market rates of interest and receives interest and the face amount in return, over the bond term.

Bond date

Bond date -- The first possible issuance date. This date is listed on the bond.

Bond issue costs

Bond issue costs -- The cost of printing, registering, and marketing the bonds

Bond price

Bond price -- The current market price of a bond exclusive of accrued interest

Bond proceeds

Bond proceeds -- The sum of the bond price and any accrued interest

Bond term

Bond term -- The period from issuance date to maturity date

Callable vs. redeemable

Callable vs. redeemable -- An issuer can retire callable bonds before maturity at a specified price. The bondholder can require a redeemable bond to be retired early.

Convertible vs. nonconvertible

Convertible vs. nonconvertible -- A convertible bond can be converted into capital stock by the bondholder; a nonconvertible bond cannot.

Determination of Selling Price of the Bond (Initial Book Value)

Determination of Selling Price of the Bond (Initial Book Value) -- The selling price of a bond is equal to the present value of future cash flows related to the bond financial instrument (principal and cash interest). The discount rate used for this calculation is the market rate of interest on the date the bonds are issued.

What method is used for premium/discount amortization?

Effective interest method.

Interest payment dates

Interest payment dates -- The dates the bond pays the cash interest. Two interest payment dates per year is the norm.

Issuance date

Issuance date -- The date the bonds are actually issued. This date cannot be earlier than the bond date but frequently is later. This information is not on the bond.

Market (yield, effective) interest rate

Market (yield, effective) interest rate -- The rate equating the sum of the present values of the cash interest annuity and of the face value single payment, with the bond price. If a 6%, $1,000 bond was issued for $900, the market rate of interest equates the $900 amount with the present value of the annuity of $60 (or $30 twice a year), and the $1,000 face value to be paid in the future. The market rate is the true compounded rate of return on the bond. This rate is determined by the market and does not appear on the bond.

Define "serial bonds".

Mature serially, that is at regular or staggered intervals.

Maturity date

Maturity date -- The date the maturity value is paid, the end of the bond term.

Define "secured bonds".

Secured bonds have a claim to specific assets.

Secured vs. unsecured (debentures)

Secured vs. unsecured (debentures) -- A secured bond issue has a claim to specific assets. Otherwise, the bondholders are unsecured creditors and are grouped with other unsecured creditors. An unsecured bond is backed only by the credit rating of the issuing firm and is called a debenture.

Serial vs. single maturity term

Serial vs. single maturity term -- A serial bond matures serially, that is at regular or staggered intervals. The principal is paid gradually rather than all at once, as is the case with a single maturity or term bond.

Stated (coupon) interest rate

Stated (coupon) interest rate -- The rate at which the bond pays cash interest. The rate is stated on the bond. If the rate is 6% and the bond's face value is $1,000, then one bond pays $60 interest each year.

Straight-line (SL) method

Straight-line (SL) method -- This method recognizes a constant amount of amortization each month of the bond term. The straight-line method should not be used when (a) the term to maturity is quite long and there is more than a minor difference between the market and stated rates, or (b) when there is a very significant difference between the market and stated rates regardless of the length of the term. An example of (b) is a zero coupon bond. Such bonds pay no interest (stated rate = 0). However, they yield competitive rates. The effective interest method must be used for these bonds.

Define "issuance date".

The date the bonds are actually sold.

Define "maturity date".

The date the maturity value is paid, the end of the bond term.

Define "bond date".

The first possible issuance date.

Purpose of Amortization

The purpose of amortization of the premiums and discounts is to adjust interest expense to reflect the market rate of interest and to ensure that the book value at maturity equals face value. Through adjustment of the selling price of the bonds (that is, the bonds are issued at a premium or a discount), all bonds ultimately "pay" the market rate of interest.

Bond Accounting Principles

This is a major topic on the CPA exam. A bond is a long-term debt instrument issued to many different creditor/investors. A bond contrasts with a note that represents the debt for a borrowing from a single creditor. Bond issuance allows more capital to be raised because it can attract many more creditors. The main issues are recording the bond at issuance, recognizing interest expense, and recognizing any gain or loss on retirement.

Example: Straight-line (SL) method

Using the previous example of computing the bond price, the June 30 entry in year of issuance under the straight-line method is: (note : The interest expense amount is a "plug" figure.) Interest Expense 38 Discount on Bonds Payable 8 ($67/48 months)(6 months) Cash $1,000(.03) 30 The bond term is 4 years long or 48 months. Six months have elapsed since the issuance of the bonds. The entry at each interest date is the same as the one above for the straight-line method. The interest expense is the same amount for each entry, but the ratio of interest expense to beginning book value changes because book value changes each period with the amortization of discount. The resulting book value is only an approximation to the present value of remaining payments.

When are bonds sold at a discount?

When stated rate < market rate.

When are bonds sold at a premium?

When stated rate > market rate.

Accrued interest on bond sale

Accrued interest on bond sale -- The amount of interest, based on the coupon interest rate for the period, between the issuance date and the immediately preceding interest payment date

Describe the valuation of long-term liabilities.

1. Initially recorded at the present value of future cash flows; 2. Interest and amortization are recognized at the market interest rate the date the liability was established; 3. Interest expense equals the liability balance at the beginning of the period times the market rate of interest the date the liability was recorded.

Define "bond".

A financial debt instrument that typically calls for the payment of periodic interest (although a zero-coupon bond pays no interest), with the principal being due at some time in the future.

Amortize Premium

A. Amortize Premium -- 1. When a premium is amortized, the bond interest expense is adjusted downward to reflect the lower market rate of interest. An example entry is: Interest Expense xx Premium on Bond xx Cash xx 2. Cash interest exceeds interest expense because the firm received an amount exceeding face value but will pay back only face value. The total interest cost to the firm over the bond term is the total cash interest paid less the total premium, which is retained by the firm.

There are seven items of information that must be known to account for a bond:

A. There are seven items of information that must be known to account for a bond: 1. Face (maturity) value 2. Stated (coupon) interest rate 3. Interest payment dates 4. Market (yield, effective) interest rate 5. Bond date 6. Issuance date 7. Maturity date

Example: A bond issued at a discount:

Example: A bond issued at a discount: A 6%, $1,000 bond dated 1/1/x7 is issued on that date to yield 8%. The bond pays interest each June 30 and December 31 and matures four years from issuance. The bond price equals: $1,000(PV of $1, I = 4%, N = 8) + .03($1,000)(PV of $1 annuity, I = 4%, N = 8) = $1,000(.73069) + $30(6.73274) = $933 The price (present value) is computed using the market rate of interest. 4% is used rather than 8% because the bonds pay interest semiannually. The 3% interest rate is used only to compute the semiannual interest payment. The bond sells at a discount because investors can earn 8% on competing bonds. The price of these bonds must fall in order for them to be issued. The stated rate cannot be changed, so the only variable left to change is the price. The bondholder is paying less than face value but will receive face value in return. Thus, the yield rate exceeds the coupon interest rate. Bond prices are expressed in percentage of face value. This bond was issued at 93.3, or 93.3% of face value. Bond prices are always quoted exclusive of any accrued interest. The entry to record the issuance of the bond is: Cash 933 Discount on Bonds Payable 67 Bonds Payable 1,000 The noncurrent liability section of the balance sheet immediately after issuance would disclose: Bonds Payable $ 1,000 Less Discount on Bonds Payable (67) Net Bonds Payable $ 933 The $933 amount is the net bond liability or book value of the bond issue. The bonds payable account is always measured at face value. The discount and premium are contra or adjunct accounts that reduce or increase the net liability to present value. With interest rate changes after issuance, the fair value of the bond most likely is not $933. In the last year of the bond term, the net liability is reported as a current liability, often called "current maturities of long-term debt."

Example: Effective interest method

Example: Using the previous example of computing the bond price, the June 30 entry in year of issuance under the effective interest method is: Interest Expense $933(.04) 37 Discount on Bonds Payable 7 Cash $1,000(.03) 30 The net book value of the bonds is now $940 ($933 + $7). That is the amount on which interest expense at December 31 is computed. Under the effective interest method, the book value changes with each interest entry. Therefore, each entry recognizes a different amount of interest expense. But the ratio of interest expense to beginning book value is constant and equals the effective interest rate. The resulting book value is the present value of remaining cash payments using the yield rate at issuance.

Face (maturity) value

Face (maturity) value -- The amount paid to the bondholder at maturity. This amount is often $1,000.