# Bonds

## Key Things to Know

### Intermediate Accounting 2

## Key Things To Know

** Bonds –**

A long-term payable, borrow from investors (the lender is an investor)

Account for a bond like all other long-term liabilities:

**Record the borrowing of money: **

Cash

Bond Payable

**Record interest expense incurred**** & pay interest expense **

Interest Expense

Discount/Premium (db or cr)

Cash

**Repay maturity value on the maturity date: **

Bond Payable

Cash

**The following terms of the bond contract do not change:**

Maturity Value:

Amount to be repaid on the maturity date

Maturity Date:

Date the maturity value must be repaid

Stated Interest Rate:

Interest **paid in cash** periodically

(maturity value x stated rate / # payments per year)

**Bonds have two interest rates:**

**Stated Rate: **

Amount of** cash paid** for interest periodically.

Stated in the bond contract and does not change

Cash paid = (Maturity value x stated %) / # payments each year

**Market Yield/Effective interest rate:**

The amount the company really incurs and the investor earns.

This rate fluctuates with the market.

The effective market rate determines the present value of the bond (cash exchanged)

**Simplified Example: **

$1,000 Bond, 10% Stated interest (annual stated)

The bond will pay $100 interest ($1,000 * 10%)

*The market rate moves opposite of the price of the bond*

If investor lends $1,000, actually earn 10%

100/1000 = 10% effective

If investor lends $900, actually earn 11.1%

100/900 = 11.1% effective

If investor lends $1,100, actually earn 9.1%

100/1100 = 9.1% effective

**Bond Pricing:**

The investor loans an amount that gives a market rate of interest earned given the time to maturity and the level of risk.

**Cash exchanged =** present value of cash flow streams at the market effective rate

1) Interest paid according to bond contract

2) Principal repaid on the maturity date

PV of cash flows is often stated in a bid ask quote:

Example: 109.8 for a $100,000 maturity value bond is a price of $109,800

$100,000

x 1.098

= $109,800

**Determine the bond price:**

Stated payment x present value factor of an ordinary annuity

+

Maturity value x present value factor of a single amount

= Price of bond (cash exchanged)

The price is the cash exchanged on the borrow date to get the desired market rate of return.

The borrower (issuer) will repay the maturity value on the maturity date regardless of the cash exchanged on the borrowing date.

**Discount / Premium:**

The difference in cash received and the maturity value is reported over time as more or less interest expense/revenue by the borrower/investor.

**Discount (initial debit):**

Cash exchanged is less than maturity value

*Premium (initial credit):*

Cash exchanged is more than maturity value

**Amortization Table:**

Used to determine the amount of interest expense/revenue

Effective Interest =

the market rate for the period x carrying value at end of last period

Stated Interest =

the stated rate for the period x maturity value (always the same)

Difference =

Effective Interest – Stated Interest

(changes the discount or premium)

Carrying value is adjusted for the difference until eventually = 0

Effective Interest | Stated Interest | Difference | Carrying value |

“Yield” rate | “Stated” rate | Cash exchanged: | |

“Market” rate | “stated” rate | Present value of | |

future cash flows | |||

Interest Expense | Interest Payable | Discount/Premium | Get to Maturity Value |

**__________________________________________________________________________________________________________________**

The bond amortization schedule will have the original bond date and all payment dates.

The bond schedule will not change regardless of when the bond is actually issued.

Insert new rows for any date that occurs that is not the original bond date or a payment date.

**__________________________________________________________________________________________________________________**

**Issuer: Journal Entries**** When issued on the original bond date:**

**Issue the Bond:**

Cash $ amount of cash exchanged = PV of future CF Discount or Premium $ difference in cash and maturity value Bonds Payable $ maturity value |

**Interest is paid:**

Interest Expense $ from amortization table Discount or Premium $ difference in cash paid and interest expense Cash $ full stated amount |

**Issuer: Journal Entries**** When issued on a date that is not the bond date:**

**Issue Bond:**

Cash $ present value on issue date + interest payable Discount or Premium $ diff in maturity value and present Interest Payable $ stated rate for time already passed Bonds Payable $ maturity value |

1st Period Interest is Paid:

Interest Expense $ from amortization table for months passed Interest Payable $ amount accrued when issued the bond (if any) Premium or Discount $ difference in cash paid and interest expense Cash $ full stated amount |

Interest expense = the amount for the time from the current date to the last date an interest expense entry was made.

**Accrue Interest**

at the end of a period (year end) that is not a payment date

Interest Expense $ effective interest column for partial period Premium or Discount $ difference Interest Payable $ stated column for partial period |

__________________________________________________________________________________________________________________

Investor Journal Entries:

**Purchased is on the bond date: **

Investment

Cash

**Purchase is not on the original bond date:**

Investment

Interest Receivable

Cash

**Record Interest Earned (investor)**

**When issued on the bond date: **

Cash

Investment

Interest Revenue

**When issued between bond dates**

Cash

Investment (db or cr)

Interest Receivable

Interest Revenue

**Accrue at the end of the period**

Interest Receivable

Investment (db or cr)

Interest Revenue

**Early repayment of debt: Redemption (See Practice as You Learn for Example)**

Step 1. Insert another row for the date that the redemption/repayment is made

Step 2. Record the payment of interest incurred since the last payment date.

Step 3. Remove the bond at the carrying value on the redemption date and record cash paid to repay

Step 4. Plug to a gain or loss on early repayment.

**Convertible Bonds:**

The Company issues common stock to repay the bond

Same steps 1. & 2. above.

Remove the bond at the carrying value on the early conversion date

Increase common stock at par x # shares issued and plug to paid in capital to balance.

No gain or loss on a conversion