Serial Bonds. Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 1

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1 Serial Bonds Description: Bonds that provide for installment liquidation of principal. Bonds with differing maturity dates no doubt sell at different prices (different risk to investor). GAAP does not address assignment of different rates of interest for each term - it has been assumed that the issue yields a single interest rate. In rare instances, bonds can be treated as simply several term issues. When bonds are issued and each term is sold with identifiable interest rates, then bonds can be accounted for as individual term issues. When serial bonds are issued and the yield rate for each term issue cannot be determined, then two methods are available: Effective Interest Method: Determine the effective interest rate (IRR for most spreadsheet programs) for the cash outflows and use this rate to calculate interest expense. Difference between interest expense and interest paid produces the amortization of premium or discount on the bonds. Bonds Outstanding Method: Determine premium or discount proportionate to the face value of the bonds outstanding at the beginning of a period to the total bonds outstanding for all periods. (Sort of a sum of the bonds digits approach) Early Retirement of Serial Bonds Gain or loss calculated on the difference between call or retirement price and carrying value at date of retirement. Classification as an extraordinary gain or loss is no longer automatic. Since the issuance of FASB No. 145, gains and losses from the early retirement of debt will be included in income from operations unless the event meets the usual rules (i.e., unusual in nature and infrequent in occurrence) Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 1

2 Serial Bond Example: NQK Inc. issues $100,000 face value of semi-annual bonds with stated interest rate of 12% on January 1, 20X1. Principal in the amount of $20,000 will be repaid each year beginning 12/31/X1 until the bonds are fully retired. Interest is paid on June 30 and December 31 of each year. The amount received from Investment Banker is $95,409. Stated interest rate 12% Yield rate? Total face value 100,000 Face value per year 20,000 Bond period in years 5 Interest payments per year 2 Proceeds of bond issue 95,409 For the effective interest method, the first step is to determine the effective interest rate. How can we do this? Is it an ordinary annuity problem? Cash flows: Period Interest Paid Principal Re-paid Cash Flow Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 2

3 Effective Interest Amortization - Serial Bond Period Interest Paid Principal Repaid Interest Expense Amount Amortized Carrying Value of Bonds Premium or Discount Balance Face Value of Bonds Outstanding Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 3

4 Bonds Outstanding Amortization - Serial Bonds Period Interest Paid Principal Re-paid Interest Expense Amount Amortized Carrying Value of Bonds Premium or Discount Balance Face Value of Bonds Outstanding Amortization Fraction Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 4

5 Solution for Example Problem EFFECTIVE INTEREST AMORTIZATION SCHEDULE 6.00% 7.000% Face Value: 100,000 Period Date Interest Principal Interest Amorti- Carrying BALANCE FACE Paid Payment Expense zation Value DISCOUNT VALUE 0 01/01/ ,409 (4,591) 100, /30/01 6,000 6,679 (679) 96,088 (3,912) 100, /31/01 6,000 20,000 6,726 (726) 76,814 (3,186) 80, /30/02 4,800 5,377 (577) 77,391 (2,609) 80, /31/02 4,800 20,000 5,417 (617) 58,008 (1,992) 60, /30/03 3,600 4,061 (461) 58,468 (1,532) 60, /31/03 3,600 20,000 4,093 (493) 38,961 (1,039) 40, /30/04 2,400 2,727 (327) 39,288 (712) 40, /31/04 2,400 20,000 2,750 (350) 19,638 (362) 20, /30/05 1,200 1,375 (175) 19,813 (187) 20, /31/05 1,200 20,000 1,387 (187) /30/ (0) Journal entries: Effective Interest Method Debit Credit 01/01/01 Cash 95,409 Discount on Bonds Payable 4,591 Bonds Payable 100,000 06/30/01 Interest Expense 6,679 Discount on Bonds Payable 679 Cash 6,000 12/31/01 Interest expense 6,726 Bonds Payable 20,000 Discount on Bonds Payable 726 Cash 26, , ,405 Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 5

6 Serial Bond Example Bonds Outstanding Method Comments: The amortization fraction is determined based on total principal outstanding at each interest payment date. It is similar to sum of the years digits depreciation.. Note that the first fraction is 100/600 and the last fraction is 20/600. With this method, we do not need to know the effective interest rate. Before calculators and spreadsheets, the bonds outstanding method was the only efficient way to handle a serial bond! 6.00% Face Value: 100,000 Period Date Interest Principal Interest Amorti- Carrying BALANCE FACE Amortization Paid Payment Expense zation Value DISCOUNT VALUE Fraction 0 01/01/ ,409 (4,591) 100, /30/01 6,000-6,765 (765) 96,174 (3,826) 100,000 10/600 = /31/01 6,000 20,000 6,765 (765) 76,939 (3,061) 80,000 10/600 = /30/02 4,800-5,412 (612) 77,551 (2,449) 80,000 80/600 = /31/02 4,800 20,000 5,412 (612) 58,164 (1,836) 60,000 80/600 = /30/03 3,600-4,059 (459) 58,623 (1,377) 60,000 60/600 = /31/03 3,600 20,000 4,059 (459) 39,082 (918) 40,000 60/600 = /30/04 2,400-2,706 (306) 39,388 (612) 40,000 40/600 = /31/04 2,400 20,000 2,706 (306) 19,694 (306) 20,000 40/600 = /30/05 1,200-1,353 (153) 19,847 (153) 20,000 20/600 = /31/05 1,200 20,000 1,353 (153) /600 = ,000 Journal entries: Bonds Outstanding Method Debit Credit 01/01/01 Cash 95,409 Discount on Bonds Payable 4,591 Bonds Payable 100,000 06/30/01 Interest Expense 6,765 Discount on Bonds Payable 765 Cash 6,000 12/31/01 Interest expense 6,765 Bonds Payable 20,000 Discount on Bonds Payable 765 Cash 26, , ,530 Serial Bonds Notes and example (no HW).doc as of 8/24/10 Page 6