bond accounting

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Principles of Financial Accounting

Chapter 9

Bond Accounting(p. 390-404)

Professor Lucile Faurel – Principles of Financial AccountingChapter 9 – Bond Accounting 2

Introduction to BondsBonds are formal certificates of debt that promise to pay:

A specified amount of interest in cash annually or semi-annually.A specified principal at a specific maturity date.

Vocabulary:Bonds are “issued” by companies (“issuers”) that wish to borrow money from the general public. Bonds are issued to multiple lenders / investors (“bondholders”).The face value (also called par value or maturity value) is the principal the company is required to pay at maturity.The coupon rate (also called nominal interest rate, contractual rate,

stated rate) determines the amount of interest the company is required to pay every year.

Bonds generally pay interest every 6 months (i.e. semi-annually).

“Convertible” bonds refer to bonds that can be exchanged, at the holders’ option, for other securities.

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Valuing Bonds

Because bonds create cash flows in future periods, they are recorded at the present value of those future payments, discounted at themarket interest rate in effect when the liability is created.

When valuing bonds, the present value tables are used to determine the amount of proceeds that will be received (i.e. the “price” of the bonds).

The present value of $1 table (Table 9A-2, p.422) is used to determine the present value of the face amount (principal) of the bonds.The present value of an annuity of $1 (Table 9A-3, p.423) is used to determine the present value of the series of interest payments.The amounts are added together to determine the amount of proceeds and any resulting discount or premium.


Proceeds on Bond Issuance

A. Market Interest Rate = 7% = Coupon RateProceeds = $100,000.Bond sold at par.

B. Market Interest Rate = 8% > Coupon RateProceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377.Bond sold at a discount.

C. Market Interest Rate = 6% < Coupon RateProceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710.Bond sold at a premium.

Bond: Face Amount: $100,000 Term: 3 years Coupon Rate: 7% Interest Payments: $3,500 paid semi-annually

4%, 6 periods, Table 9A-3

($100,000 * .07)/2


3%, 6 periods, Table 9A-2 3%, 6 periods, Table 9A-3

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Par, Discount & Premium

If the market rate is EQUAL to the coupon rate, the bond will sell at PAR.

If the market rate is ABOVE the coupon rate, the bond will sell at a DISCOUNT.

If the market rate is BELOW the coupon rate, the bond will sell at a PREMIUM.


Coupon Rate vs. Market Rate

The coupon (interest) rate is:The rate of interest stated on the bond.The interest to be paid in cash every year by the issuing company.

Used to calculate the amount of interest payments (paid in cash).

The market (interest) rate (or effective interest rate, yield to maturity) is:The rate available on investments in similar bonds at a moment in time.

Used in the present value calculations when determining the proceeds on issuance.

Used to calculate the amount of interest expense to recognize.

Changes in the market rate after the bonds are issued do NOT affect the interest expense recognized.

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Effective Interest Amortization

How do we decrease the bond discount or bond premium? Straight-line amortization (not GAAP)

The discount or premium is amortized in equal amounts each period.

Effective interest amortization

The discount or premium is amortized over the life of the debt.

The interest expense is equal to the market interest rate (at the time of issuance) multiplied by the amount of debt outstanding at the beginning of the given period.

The difference between the interest expense and the cash paid (for interest payments) represents the amortization of the discount or premium.


Discount Amortization

Journal entry upon bond issuance:Dr. Cash 97,377

Cr. Bonds Payable 97,377

Journal entry for interest expense, end of Period 1 (6 months after issuance):Dr. Interest Expense 3,895

Cr. Cash (or Interest Payable) 3,500Cr. Bonds Payable 395

Journal entry at maturity (end of Period 6):Dr. Bonds Payable 100,000

Cr. Cash 100,000

Bonds Payable,

End(e=a+d)

Amortization of Discount

(d=b-c)

Cash Payment

(c)

Interest Expense

(4%)(b=a*4%)

Bonds Payable,

Beg.(a)

Period

1 97,377 3,895 3,500 395 97,7722 97,772 3,911 3,500 411 98,1833 98,183 3,927 3,500 427 98,6104 98,610 3,944 3,500 444 99,0555 99,055 3,962 3,500 462 99,5176 99,517 3,983 3,500 483 100,000

Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).

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Premium Amortization



Journal entry for interest expense, end of Period 4 (2 years after issuance):Dr. Interest Expense 3,042Dr. Bonds Payable 458

Cr. Cash (or Interest Payable) 3,500


Cr. Cash 100,000

Bonds Payable,

End(e=a+d)

Amortization of Premium

(d=b-c)

Cash Payment

(c)

Interest Expense

(3%)(b=a*3%)

Bonds Payable,

Beg.(a)

Period

1 102,710 3,081 3,500 -419 102,2912 102,291 3,069 3,500 -431 101,8603 101,860 3,056 3,500 -444 101,4164 101,416 3,042 3,500 -458 100,9585 100,958 3,029 3,500 -471 100,4876 100,487 3,013 3,500 -487 100,000

Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).




Journal entry for interest expense at the end of each period:Dr. Interest Expense 3,500

Cr. Cash (or Interest Payable) 3,500


Cr. Cash 100,000

Bonds Payable,

End(e=a+d)

Amortization of Discount / Premium(d=b-c)

Cash Payment

(c)

Interest Expense (3.5%)

(b=a*3.5%)

Bonds Payable,

Beg.(a)

Period

6 100,000 3,500 3,500 - 100,000

4 100,000 3,500 3,500 - 100,0005 100,000 3,500 3,500 - 100,000

2 100,000 3,500 3,500 - 100,000

Bond Issued at Par

1 100,000 3,500 3,500 - 100,000

3 100,000 3,500 3,500 - 100,000

Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).

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Practice Problem A A company issues a 2-year bond with a face value of $20,000 and a coupon rate of 10%.

Interest is paid and compounded semi-annually on June 30 and December 31 of each year. At the time of issuance, the market rate is 12%.

1. What is the amount of the proceeds from the issuance of this bond?Proceeds = $20,000 * 0.7921 + $1,000 * 3.4651 = $19,307.

Bond sold at a discount.

6%, 4 periods, Table 9A-26%, 4 periods, Table 9A-3

Interest payment = ($20,000 * 10%)/2 =

$20,000 * 5% = $1,000


Practice Problem A A company issues a 2-year bond with a face value of $20,000 and a coupon rate of 10%. At the time of issuance, the market rate was 12%.2. Write out ALL journal entries related to this bond (i.e. from issuance

until maturity).

Issuance, beg of period 1:Dr. Cash 19,307


End of period 1:Dr. Interest Expense (19,307*.06) 1,158

Cr. Cash 1,000Cr. Bonds Payable 158







Maturity, end of period 4:Dr. Bonds Payable 20,000

Cr. Cash 20,000

19,307+158

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Practice Problem B A company issues a 2-year bond with a face value of $20,000 and a coupon rate of 10%.

Interest is paid and compounded semi-annually on June 30 and December 31 of each year. At the time of issuance, the market rate is 8%.

1. What is the amount of the proceeds from the issuance of this bond?Proceeds = $20,000 * 0.8548 + $1,000 * 3.6299 = $20,726.

Bond sold at a premium.

4%, 4 periods, Table 9A-24%, 4 periods, Table 9A-3

Interest payment = ($20,000 * 10%)/2 =

$20,000 * 5% = $1,000


Practice Problem B A company issues a 2-year bond with a face value of $20,000 and a coupon rate of 10%. At the time of issuance, the market rate was 8%.2. Write out ALL journal entries related to this bond (i.e. from issuance

until maturity).

Issuance, beg of period 1:Dr. Cash 20,726


End of period 1:Dr. Interest Expense (20,726*.04) 829Dr. Bonds Payable 171

Cr. Cash 1,000


Cr. Cash 1,000


Cr. Cash 1,000


Cr. Cash 1,000

Maturity, end of period 4:Dr. Bonds Payable 20,000

Cr. Cash 20,000

20,726-171

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Early Extinguishment of BondsFirms that issue bonds do not always hold the bonds to maturity.

They can repurchase bonds on the open market, or They can call back bonds at a pre-specified price (if the bonds are issued with a “call” provision).

Early extinguishments of debt usually result in a gain or loss. Gain (loss) on early extinguishment = Book value of debt – price paid for debt (i.e. market value).

Book value of bond = face value – unamortized discount or premium = balance of Bonds Payable account at the time of the early extinguishment.

Since 2002, gains and losses from early extinguishment of debt are usually classified as “other income” on the income statement.

Special item “above the line,” i.e. not included in operating income.


Fiscal Year Ended April 30, 2002 2003 2004 Revenues $ 421,235 $ 420,863 $ 439,686

Operating expenses: Cost of operations 276,693 278,347 287,309 General and administration 54,456 55,772 58,198 Depreciation and amortization 50,712 47,930 59,673 Impairment charge — 4,864 1,663 Restructuring charge (438) — —

381,423 386,913 406,843 Operating income 39,812 33,950 32,843 Other expense/(income), net:

Interest income (904) (318) (251 )Interest expense 31,451 26,572 25,648 Income from equity method investments (1,899) (2,073) (2,261 )Loss on debt extinguishment — 3,649 — Minority interest (154) (152) — Other expense/(income) (4,480) (1,599) 5,948

Other expense, net 24,014 26,079 29,084

Income from continuing operations 15,798 7,871 3,759

CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)

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Early Extinguishment of BondsJournal Entry

Consider the discount bond examined in slide 8. The company decides to repurchase this bond on the first day of Year 3.

At the end of Year 2 (i.e. Period 4), the book value is $99,055.

Assume the company repurchases the bond for $90,000:Gain (Loss) = $99,055 – $90,000 = $9,055 of GAIN.

Dr. Bonds Payable 99,055Cr. Cash 90,000Cr. Gain on Early Extinguishment 9,055

Now, assume the company repurchases the bond for $110,000:Gain (Loss) = $99,055 – $110,000 = $(10,945) of LOSS.

Dr. Bonds Payable 99,055Dr. Loss on Early Extinguishment 10,945

Cr. Cash 110,000


Noninterest-Bearing BondsNoninterest-bearing bonds (also called zero coupon bonds):

Pay no interest (i.e. the coupon rate is 0%) during their life and thus are issued at very deep discounts.

Example:

Consider a 4-year zero coupon bond with a face value of $1,000. The market rate at the time of issue is 10% (compounded semi-annually).

Journal entry to record the issuance:Proceeds = 1,000 * 0.6768 = $677.

Journal entry:Dr. Cash 677

Cr. Bonds Payable 677


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Bonds Payable,

End(e=a+d)

Amortization of Discount

(d=b-c)

Cash Payment

(c)

Interest Expense

(5%)(b=a*4%)

Bonds Payable,

Beg.(a)

Period

1 677 34 – 34 7112 711 36 – 36 747

3 747 37 – 37 784

4 784 39 – 39 823

5 823 41 – 41 864

6 864 43 – 43 907

Noninterest-Bearing BondsExample (cont’d):

Amortization schedule:

7 907 45 – 45 952

8 952 48 – 48 1,000


Noninterest-Bearing BondsExample (cont’d):

Journal entries to record accrued interest:

At end of period 1:Dr. Interest Expense 34
















677 * .05

(677+34) * .05

bond accounting

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