How to Account for Bonds

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1 How to Account for Bonds Chapter 10c DETAILED SUMMARY Mark Krilanovich October 25, 2012 ACCT 230 In this document, "we" means "our company," "the buyer" means "the person who buys our bond," and "the owner" means "the person who owns the bond." This document assumes all interest payments are annual (rather than semi-annual). Three categories of issue price: p "At par:" (issue price) = (face amount); no discount or premium. 2. "At a discount:" the total bond discount = (face amount) - (issue price). 3. "At a premium:" the total bond premium = (issue price) - (face amount). Who cares about the issue price? The buyer does not care at all whether he buys at par, at a discount, or at a premium, because he cares only about his rate of return on his purchase (p.519). We care about the issue price, because we pay more total interest expense for discount bonds (p.524), which is more than for at-par bonds, which is more than for premium bonds (p.529). Our total interest expense over the bond's life equals: (the total dollars we pay out) - (the total dollars we receive) We determine the left item in bold before we issue the bond (principal plus all the cash interest payments). The right item in italics (the sales price) is the only one we can't control. [This formula shows that for every dollar the sales price goes down, it adds one dollar to our total interest expense.] Why do we amortize the discount or premium on our bond? p.524 To follow the Matching Principle. We must match the expense of borrowing money in the same year that we use the money to earn revenue Discount: we receive a sales price less than the total dollars we will pay out; the difference ("bond discount") increases our interest expense of the bond. By the Matching Principle, we must amortize the discount (additional interest) over the life of the bond. p Premium: we receive a sales price more than the total dollars we will pay out; the difference ("bond premium") decreases our interest expense of the bond. By the Matching Principle, we must amortize the premium (reduction in interest) over the life of the bond. p Par: we receive a sales price equal to the total dollars we will pay out. Therefore, there is no discount or premium to amortize, since the total interest paid is equal to the total interest expense. 1 This happens automatically for the annuity payments. To prove this to yourself, write all the journal entries for the life of a bond sold at discount or premium without doing any amortization. Where does the total discount/premium fall?

2 Bonds detailed, Chapter 10, page 2 Two ways we can amortize our bond discount or premium: p Straight-Line. For each interest payment, the discount or premium is amortized by the same amount, causing the interest expense for each payment to be the same. (GAAP allows Straight-Line only if its amounts aren't materially different from the Effective-Interest method.) 2. Effective-interest. Our periodic interest expense depends on the market rate of interest at the original date of sale (which is fixed for the life of the bond). For each payment, our interest expense changes according to the current unpaid balance of the bond ("book value"). For any payment, our interest expense is: Interest Expense = (Current Book Value) x (Market Rate at Original Sale) The above calculation shows the discount or premium to be amortized by a different amount for each interest payment. This Summary won't say anything more about Straight-Line Amortization, which simply spreads our total interest expense evenly over time, with equal dollar amounts at each interest payment. It's easy to do, and rarely allowed by GAAP. This Summary won't say anything more about bonds issued at par, because it's so rare that the market rate at sale exactly equals our stated rate, and because bonds at par are simple to account for. Thus, the rest of this document will deal only with Effective-Interest Amortization (because it's more accurate, and required by GAAP), and with bonds issued at a discount or premium (because they're far more common). How to account for bond events: So far this summary has given only definitions and background information. The core of this chapter is how to record journal entries for the three events during the life of a bond: a. Sale of the bond to the owner. b. Periodic interest payments to the bond's owner. c. Redemption of the bond at maturity. The textbook teaches these journal entries separately for (bonds sold at discount vs. bonds sold at premium vs. bonds sold at par) X (straight-line amortization vs. effective-rate amortization), which is a total of six different sets of journal entries! That's too complicated! This chapter summary simplifies by eliminating straight-line amortization (you can figure it out on your own, and it's seldom used) and bonds sold at par (they rarely are). That leaves bonds sold at a discount vs. bonds sold at a premium, via the Effective- Interest Rate Method, just two sets of journal entries. And those two are far more similar than they are different, as the chart on the next page visually shows.

3 Bonds detailed, Chapter 10, page 3 Journal Entries for Bond Events There are more similarities than differences in the journal entries to record events during the life of a bond sold at a premium versus a bond sold at a discount. In the table below, every aspect in black is the same between the two. The differences in green are differences in name only ("premium" versus "discount"). The differences in red are differences only in algebraic sign (because "premium" > "discount"). event for a bond sold at a discount for a bond sold at a premium initial sale of the bond periodic cash interest payments redemption of the bond at maturity a. Debit Cash by the bond's issue price, b. Debit "Discount on Bonds Payable" by the total bond discount amount, c. Credit "Bonds Payable" by the bond's face amount. a. Compute our Interest Expense as: (Current Book Value) x (Market Rate at Sale) b. Compute the Amortization Amount as: (Interest Expense) - (Cash Interest Payment) i. Debit "Interest Expense" (from above), ii. Credit "Discount on Bonds Payable" by the Amortization Amount, iii. Credit Cash by our Cash Interest Payment. c. Compute new Book Value as: (Previous Book Value) + (Amortization Amount) a. Debit "Interest Expense," b. Debit "Bonds Payable" by the bond's face amount (leaving it zero), c. Credit "Discount on Bonds Payable" by the Amortization Amount (leaving it zero), d. Credit Cash by the sum of: i. our Cash Interest Payment (final interest payment) ii. the face amount of bond (pay maturity value). a. Debit Cash by the bond's issue price, b. Credit "Premium on Bonds Payable" by the total bond premium amount. c. Credit "Bonds Payable" by the bond's face amount. a. Compute our Interest Expense as: (Current Book Value) x (Market Rate at Sale) b. Compute the Amortization Amount as: (Cash Interest Payment) - (Interest Expense) i. Debit "Interest Expense" (from above), ii. Debit "Premium on Bonds Payable" by the Amortization Amount, iii. Credit Cash by our Cash Interest Payment. c. Compute new Book Value as: (Previous Book Value) - (Amortization Amount) a. Debit "Interest Expense," b. Debit "Bonds Payable" by the bond's face amount (leaving it zero), c. Debit "Premium on Bonds Payable" by the Amortization Amount (leaving it zero), d. Credit Cash by the sum of: i. our Cash Interest Payment (final interest payment) ii. the face amount of bond (pay maturity value). See the last pages of this Summary for your chance to practice recording these journal entries. Learn by doing.

4 Bonds detailed, Chapter 10, page 4 Comparisons of bonds sold at a discount versus a premium: (Remember, we're discussing only Effective-Interest Amortization.) 1. Book Value: a. Bonds sold at a discount increase book value over time. b. Bonds sold at a premium decrease book value over time. c. Both reach the face amount at the maturity date. d. Both report net liability on the balance sheet at book value. 2. Periodic Interest Expense: a. Both expense the interest over time in accord with the Matching Principle. b. Both compute it as (Current Book Value) x (Market Rate at Original Sale). c. Bonds sold at a discount increase Interest Expense with each payment d. Bonds sold at a premium decrease Interest Expense with each payment e. Bonds sold at a discount cost us more total interest expense than bonds sold at a premium. 3. Amortization: a. distributes the total discount or premium over time in accord with the Matching Principle. b. is computed as (Interest Expense) - (Cash Interest Payment). c. Bonds sold at a discount debit "Discount on Bonds Payable" (a Contra- Liability account). d. Bonds sold at a premium credit "Premium on Bonds Payable" (an Addendum Liability account). Early retirement of bond debt: p When we issue a bond, we can make it "callable," meaning that we can pay it off before the maturity date ("call it in"). Then we pay the owner a fee, and we recognize that as a loss. Or we can buy our bond on the market, which may result in a gain or a loss. Computational Examples of Amortization See the last page for examples of amortization for the full life of the identical bond, one example when it was originally sold at a discount, and the other when it was originally sold at a premium. (continued on next page)

5 Bonds detailed, Chapter 10, page 5 Visual pictures of bond variables Book Value over Time Interest Expense over Time Issue Price vs. Interest Rate

6 Effective-Interest Method of Amortization of Bonds Comparison of the same bond sold at Discount versus at Premium bonds detailed, Chapter 10, page 6 Sold at Discount market rate=7% We print all this on the bond itself: Change in bond's Book Value over time principal= $500,000 We (the issuer) set these maturity= 10 years before we issue the bond. $550,000 stated rate= 5% The market rate controls cash int. pay= $25,000 per year the rest. effective $540,000 interest $530,000 Sold at Premium market rate=4% Computation of issue price, and discount or premium, at market interest rate: $500,000 PV1= $254,175 (for maturity amount) PV1= $337,782 $490,000 PV2= $175,590 (for the cash interest payments) PV2= $202,772 $480,000 sales price= $429,764 =initial Book Value sales price= $540,554 =initial BV $470,000 discount= $70,236 (we borrow this amount less than will pay at maturity) premium= $40,554 $460,000 The goal of amortization is to spread the total discount or premium dollars over the life of the bond, following the Matching Principle. That's why the green italics total discount/premium numbers at the top match the corresponding green total amortization numbers at the bottom. $520,000 $510,000 $450,000 $440,000 $430, Once each year, we do the following calculations: Once each year, we do the following calculations: 1. interest expense = (previous year's book value) x (initial market rate) 1. interest expense = (previous year's book value) x (initial market rate) 2. amortization amount = (interest expense) - (cash interest payment) <----> 2. amortization amount = (cash interest payment) - (interest expense) 3. new book value = (previous book value) + (amortization amount) <----> 3. new book value = (previous book value) - (amortization amount) book value cash interest int. expense amortization book value cash interest int. expense amortization year from (3) (fixed) from (1) from (2) year from (3) (fixed) from (1) from (2) issue date $429,764 issue date $540,554 1 $434,848 $25,000 $30,083 $5,083 1 $537,177 $25,000 $21,622 $3,378 2 $440,287 $25,000 $30,439 $5,439 2 $533,664 $25,000 $21,487 $3,513 3 $446,107 $25,000 $30,820 $5,820 3 $530,010 $25,000 $21,347 $3,653 4 $452,335 $25,000 $31,227 $6,227 4 $526,211 $25,000 $21,200 $3,800 5 $458,998 $25,000 $31,663 $6,663 5 $522,259 $25,000 $21,048 $3,952 6 $466,128 $25,000 $32,130 $7,130 6 $518,149 $25,000 $20,890 $4,110 7 $473,757 $25,000 $32,629 $7,629 7 $513,875 $25,000 $20,726 $4,274 8 $481,920 $25,000 $33,163 $8,163 8 $509,430 $25,000 $20,555 $4,445 9 $490,654 $25,000 $33,734 $8,734 9 $504,808 $25,000 $20,377 $4,623 maturity 10 $500,000 $25,000 $34,346 $9,346 maturity 10 $500,000 $25,000 $20,192 $4,808

7 Bonds detailed, Chapter 10, page 8 Journal Entries During the Life of a Bond Sold at Premium practice exercise for the bond on the previous page event accounts debit credit sale year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 redeemption at maturity

8 Bonds detailed, Chapter 10, page 9 Journal Entries During the Life of a Bond Sold at Discount practice exercise for the bond on the previous page event accounts debit credit sale year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 redeemption at maturity Learn by doing. After you succeed at these exercises, you will have mastered the chapter.

Reporting and Interpreting Bonds

Reporting and Interpreting Bonds CHAPTER 10 McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, Inc. Not Barry and not James Slide 2 Understanding the Business The mixture of debt and equity used to finance