Bonds
A bond is a debt security
with two promises
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Long
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™A
promise
i tto pay b
back
k th
the amountt
borrowed after some period of time
(the principal)
™ A promise to make periodic interest
payments
Types of bonds
Secured vs. Unsecured Bonds
Term vs. Serial Bonds
™ Callable Bonds
™ Convertible Bonds
™ Commodity-backed Bonds
™ Deep Discount Bonds
™ Registered vs. Coupon Bonds
™ Income and Revenue Bonds
™
™
Bond Prices
™ Debt
is issued at a price which is
driven by the market rate of interest
plus risk
p
™ Theoretically the price is the
present value of future payments of
principal and interest discounted at
the market rate of interest on the
day of issue
Bond Prices
Therefore a bond’s
price is the sum of
the present value
off a single
i l amountt
(the principal)
and the present
value of an
annuity (the
periodic interest
payments)
Bond Prices
™ When
the market rate of interest is
higher than the coupon rate, the
proceeds will be less than the face
p
amount of the bond.
™ If a bond is issued at a price below
the face value, the bond is said to be
issued at a discount.
Bond Prices
™ When
the market rate of interest is
lower than the coupon rate, the
proceeds will be more than the face
p
amount of the bond.
™ If a bond is issued at a price above
the face value the bond is said to be
issued at a premium.
Effective Interest
Method
™ When
a bond is issued at a discount,
a contra account, discount on bonds
payable,
p
y
is debited.
™ When bonds are issued at a
premium, an adjunct account,
premium on bonds payable, is
credited.
Effective Interest
Method
Premiums and discounts are amortized
using the effective interest method.
™ Calculate interest expense by multiplying
the book value of the bond by the market
rate of interest at issue date.
™ The difference between the cash interest
paid and the interest expense is the
amortization of the discount or premium.
™
Bond Prices
™ The
difference between the face
value of the bond and the proceeds
is the amount of the discount.
™ The difference between the face
value of the bond and proceeds is
the amount of the premium.
Effective Interest
Method
™ Bonds
are kept on the books at
their face value
™ The book value of a bond is found by
deducting the discount from, or
adding the premium to, the face
value of the bond
Effective Interest
Method
™ Within
the effective interest
method, we use straight line
amortization when apportioning
pp
g
interest between periods.
™ So for interest it is the number of
months in the period divided by the
months between payments.
Debt Extinguishment
™
Cash exchange
– Accrue interest to
date of exchange
– Bring
B i
amortization
schedule up to date
™
Recognize gains
and losses
Debt Exchanges
When debt is exchanged for non-cash
assets, value the asset at the
discounted value of the debt
principle and interest unless there
is a high degree of certainty about
the fair market value of the asset.
Notes Payable
™ Like
bonds, notes payable are
valued at the present value of their
future interest and p
principal
p cash
flows.
™ The company amortized any
discount or premium over the life of
the notes
Deep Discount Notes
These notes bean no interest and are
thus sold at a discount substantially
below the principal amount.
™ Record the note for its principal value
and a discount for the difference in the
principal amount and the proceeds.
™ Amortize the discount using the effective
interest method.
™
Notes issued for Property
If there is a stated interest rate, record
the property at the present value of the
note.
™ If there is no interest rate stated, record
the property at the fair value of the asset
and record a discount on the note for the
difference between the fair value of the
asset and the face value of the note.
™
Installment Notes
™ In
these notes the payment consists
of part principal and part interest.
™ Recognize interest expense and
amortize the principal at each
payment.
™ Amortization of principal may be
accomplished through a discount on
note payable account.
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