Module 28.2: Discount and Premium Bonds

Zero-coupon bonds

-Also known as pure-discount bond. make no periodic interest payments. A zero-coupon bond, also known as a pure-discount bond, is issued at a discount from its par value and its annual interest expense is implied, but not explicitly paid. The actual interest payment is included in the face value that is paid at maturity. The effects of zero-coupon bonds on the financial statements are qualitatively the same as any discount bond, but the impact is larger because the discount is larger. Ex: page 242

Effective interest rate method

-Bond issued @ premium or discount, interest payments/coupon interest payments are not equal. -Interest expense: amortization of discount/premium. -Using effective interest rate method, interest rate = book value of the bond @ beginning x bond yield at issuance (1) Premium bond: interest expense < coupon payment (yield< coupon rate). Difference is the amortization of premium, which is SUBSTRACTED from each period of bond liability on B/S. Interest expense DECREASES as bond liability DECREASES (2) Discount bond: interest expense > coupon payment (yield > coupon rate). Difference is amorti of discount, which is ADDED to bond liability on B/S. Interest will INCREASE as bond liability INCREASES

Professor's Note

-Some believe classifying interest expense as CFO is non-consistent with treating the bond proceeds as a financing activity. In addition, treating interest expense as an operating activity incorrectly describes the economics of a bond issued at a premium or discount. For bonds issued @ DISCOUNT, CFO is overstated. This is because the coupon payment is CFO while the discount, when paid (as part of a bond's maturity payment), is reported CFF. Stated differently, had the firm issued the bond at par, the coupon payment would have been higher to match the market rate of interest. Reclassifying interest as a financing activity in the cash flow statement corrects this inconsistent treatment.

Cash flow

Coupon interest paid in cash. Amortization is a non-cash item. Presenting cash flow using INDIRECT method, net income must be adjusted to remove the effects of amortization of discount/premium to calculate cash flow from operations GAAP: cash interest paid: CFO. IFRS: cash interest paid CFF or CFO

IFRS and GAAP

IFRS: effective interest rate method of amortizing discount/premium is REQUIRED GAAP: effective interest rate method is PREFERRED but SL is allowed if the results are not materially different. SL: total discount/amortization at issuance is amortized by EQUAL amounts each period over the life of a bond

Professor's Note

In the case of a DISCOUNT bond, the coupon is too low relative to the required rate of return of the market. Purposes of amortizing the discount are to (1) increase the book value of the bond liability over time, and (2) increase interest expense so that the coupon payment plus discount amortization is approximately equal to the interest expense that would have prevailed had the bond been issued at par. Conversely, amortizing a premium decreases the book value of the bond liability over time and decreases interest expense.

Example: Book values and cash flows

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