Key Things To Know

Bonds Payable–
Borrow from investors who loan the company money to earn a return of interest income

The bond is a contract with the investor that loaned the money.
Every bond is a contract which has the following:

Maturity Value:
Amount that must be repaid (usually in $1,000s)

Maturity Date:
Date the maturity value amount must be repaid

Stated Interest Rate:
Cash paid periodically for interest
Interest can be paid monthly, quarterly, semi-annually or annually

Market Yield or Effective interest rate:
The interest the company actually incurs, and the investor really earns

Simplified Example:
$1,000 Maturity Value (MV) due to be paid in 10 years
10% Stated interest (annual coupon)

The bond will pay $100 interest ($1,000 MV * 10% stated)
The interest paid is in the bond contract and does not change

The investor varies the rate of return they earn by what they are willing to pay.
Whatever percent the investor earns is the same percent the company really
incurs in interest expense.

The real rate of return is the market/effective rate.

If pay $1,000, actually earn 10%
$100/$1000 = 10%

If pay $900, actually earn 11.1%
$100/$900 = 11.1%

If pay $1,100, actually earn 9.1%
$100/$1100 = 9.1%

In most cases, the cash exchanged will not be equal to the maturity value because the market rate does not equal the stated (coupon) rate.

This creates a:
Discount: Cash exchanged is less than face value
Premium: Cash exchanged is more than face value

Regardless of what is paid at the beginning, the maturity value must be paid on the
maturity date.

The actual bond market the bonds trade on determine the acceptable market rate that
investors are willing to invest to earn.

The market / effective rate changes every day.

The stated coupon rate does not change.

Determining the price of the bond:

Bonds trade on the open market at a percent of maturity value.

A bond that trades at 98 means: 98% (.98) x the maturity value is paid

For a $300,000 maturity value bond priced at 98, the investor pays $294,000
($300,000 x .98)

For a $200,000 maturity value bond priced at 125.75, the investor pays $251,500 ($200,000 x 1.2575, move the decimal point over 2 places)

Note:
Most Financial Accounting professors will not have you calculate the price of the bond and the bond price will be given to you as a number % or total amount.

If the bond price is not stated, it can be calculated using the effective interest rate
the number of periods until maturity, and the coupon rate.

Total periodic coupon payment**
x present value factor of an annuity
                                        +
Maturity value x
present value factor of a single amount

= Amount paid now to get the effective interest rate return on your money

Maturity Value x coupon %
Number of payments

=Periodic coupon payment per year

Use the PV tables to get the factor for the total number of cash payments the bond will make (years to maturity x payments each year) and the effective / market interest rate.

Journal Entries related to the bond payable:

The amount received is the cash that is exchanged between the investor and the company. This is often called “issuing a bond”, which means borrowing money.
 

Issue Bonds – Premium:			Issue Bonds – Discount:  
 Cash received > MV			          Cash received < MV

Issue:

         Cash							Cash
               Premium					        Discount
               Bond Payable (MV)					Bond Payable (MV)


Interest paid:

              Interest Expense					Interest Expense
              Premium							           Discount
                          Cash 							   Cash

Amortization Table:

Use an “Amortization Table” to determine how much of the cash payment is interest expense and how much is a discount or premium. The interest expense uses the effective/market yield rate and the cash paid is from the stated rate. These two rates are most likely different.

Effective 	        stated                                     Discount or	           Amount owed-
Interest Exp.   -   Interest	  =   Difference	     Premium	    + / -	“Carrying value”
								       
   “Yield %” 	    “Stated %” or       					            Begin with the price
   “Market %”	     “coupon %” 	                                                      of the bond - the
 							                                                     cash exchanged
   x the last		x MV                                                                     (not the MV)
   amount owed    (same for
                                all periods)


    Interest		Cash		Discount or			      End with the
   Expense				        Premium			              maturity value

Long – Term Installment Loans / Notes Payable / Mortgage Payable:

Borrow money from bank
Repay in equal payments.

The payments must cover interest expense and repayment of principle

You must determine how much of the payment is for interest expense and how much
is for repayment of loan. Use the amortization schedule for this:

Example: You borrowed $800,000 at 10% and your annual payment is $89,750.

				                    Difference:		     Amount Owed
    Payment	      Interest 10 %        to repay principle	    (Carrying value)
									            $800,000
1)	$89,750	     $80,000		    $  9,750		    $790,250
2)	$89,750	     $79,025		    $10,725		    $779,525

Journal entries:

        Borrow:		     

	Cash			$800,000		
		Note Payable	       $800,000	
				
	Interest – 1st year payment

	Interest Expense	$80,000
	Note Payable	        $  9,750
		      Cash			  $89,750

	Interest – 2nd year payment

	Interest Expense	$79,025
	Note Payable	        $10,725
		    Cash			  $89,750