Prof Albrecht s Notes Accounting for Bonds Intermediate Accounting 2

Transcription

1 Prof Albrecht s Notes Accounting for Bonds Intermediate Accounting 2 Companies need capital to fund the acquisition of various resources for use in business operations. They get this capital from owners or creditors. Many times a company will seek smaller amounts of funds via loan from a bank/financial institution, and larger amounts from capital markets via a bond issue. This is because banks seldom have the financial resources to lend extremely large amounts of money and many investors can be tapped in a bond market. In addition, restrictions imposed by banks can be more burdensome than covenants that accompany a bond issue. The purpose of this instructional resource is to review the basic issues with respect to the accounting for bonds. With a firm grounding in the accounting for loans, learning the accounting for bonds is an easy task. In essence, a bond is a type of interest bearing loan. Bonds are for several denominations, but frequently are for the amount of $1,000. Usually a large company will have thousands of bonds to issue. Let s say that on October 1, 2013, a company needs to borrow $1,000 and doesn t want to repay it for ten years. A bond certificate is created that states the company will repay the registered owner $1,000 on October 1, 2023 (ten years hence). Until then, the company promises to make regular interest payments on specific dates between now and the tenth year anniversary, when the bond matures and the company redeems the bond certificate from its registered owner with a $1,000 payment. There once was a time when bonds came with coupons that could be separated from the certificate itself. These coupons would be dated (every date of required interest payment would carry its own coupon) with the appropriate amount of interest the company was required to pay on this date ($60 if we are talking about a 6% bond for $1,000 with annual coupons, $30 if we are talking about a 6% bond for $1,000 with semi-annual coupons). The exchange transactions related to the bond are (1) on the issue date when the borrowing company sells the bond with a $1,000 maturity value and interest payments guaranteed by coupons with a rate stated on the bond certificate to an investor (alternatively, the investor buys the bond from 115

2 the company and becomes the bond owner), (2) the bond owner of record (it might be a new owner if the original owner sold the bond to another investor in a secondary market) presents a coupon on an interest date and receives a payment for interest, and (3) on the maturity date when the borrowing company redeems the matured bond (all ten years of the bond period have passed) from the current bond owner of record by paying the maturity value. This instructional resource is organized into six sections. They are: (1) accounting for bonds when the bond periods align with a company s accounting period, (2) accounting for bonds issued in a series, (3) accounting for bond issuance costs, (4) spreadsheet tips for bonds, (5) accounting for bonds when the bond periods do not precisely align with a company s accounting period, and (6) when bonds are issued between bond or interest periods. 1 Accounting for bonds when bond periods align with accounting period The accounting for bonds involves the following components: (1) computing proceeds from issuing bonds, (2) preparation of bond amortization table, (3) preparing journal entries, and (4) determining amounts needed for the balance sheet and the statement of cash flows Example 1 bonds issued at par. The Albrecht Company is planning to go to the financial market system to raise capital by selling 500 bonds of $1,000 denomination. The planned date of sale is January 1, The bonds mature in 7 years, on December 31, The bonds have a coupon rate of 10%, and coupon interest is paid annually on each December 31. When the bonds are sold, the company has a true market tested rate of interest of 10%. Bonds are said to sell at par (or to sell at % of maturity value, that is) when the stated rate of interest is equal to the market rate of interest on the date of sale. The first order of business is to compute the proceeds from sale. Ignoring for the moment any question of sales commission to the underwriters, the computation is fairly easy. PV is the amount to be computed, FV is the total maturity value ($500,000 in this case), I is the market rate of interest on date of sale (10% in this case), N is the number of discount periods (number of years times the number of compounding periods per year, 7 in this case), PMT is equal to the total coupon interest to be paid on each interest date ($50,000 = $500,000 * 0.10), and the type is always end for an ordinary annuity. It is important to always distinguish between the coupon rate of interest (frequently called the stated rate) and the market rate of interest when the bonds are taken to the investors. This market rate is used throughout the future history of accounting for the bonds, and is called the effective rate. The stated rate is used for computing the amount of cash interest payment, and the effective rate of interest is used for computing the amount of interest expense. 116

3 Spreadsheet input table Calculator values Maturity $500,000 PV? =!$500,000 Coupon (stated) interest rate % FV.... $500,000 Yield (effective interest rate % I Years N Payments per year PMT.... $50,000 Total # coupon payments Type end Total coupon payment..... $50,000 Type of Annuity (end=0) Proceeds $500,000 The bond amortization table follows the basic form for an ordinary annuity. You could prepare one that provides the basic five columns, or you could supplement it by separating the cash column into what is paid for interest and what is paid for maturity value. I prefer to use the basic five columns unless dealing with serial bonds. The exact form of the table is stylistic, choose one that provides the information you need and that you prefer. The cash interest payment amount is computed by taking the coupon or stated rate times the maturity value. The interest expense is computed by taking the effective interest rate times the bonds payable balance. When bonds have been issued at par, you get the same values for cash interest and interest expense, but not so when the original market rate of interest differs from the coupon rate. Cash Interest Bonds Pay Date Payment Expense Amort Balance Jan 1, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 Dec 31, ,000 50, ,000 The journal entries are fairly straight-forward, just like the accounting for an interest-bearing loan 1/1/2014 Cash 500,000 Bonds Payable 500,000 12/31/2014 Interest Expense 50,000 Cash 50,000 12/31/2020 Interest Expense 50,000 Cash 50,000 Bonds Payable 500,000 Cash 500,

4 Determining amounts for the financial statements follows the procedures covered in the accounting for loans. As with all liabilities, the bonds payable balance is equal to the present value of all future cash payments. The amount classified as the current liability is the present value of any payments received during the next accounting period. The long-term liability is the difference between the bonds payable balance and the current liability. On the income statement, interest expense is not included in operating income. Therefore it is included in the section on other revenues, expenses, gains and losses. On the statement of cash flows, amounts must be classified as operating activities and financing activities. The exact amount of the cash interest payment is put into the operating activities section. The amount received from investors and the amount of maturity value repaid go into the financing activities section. Inc. Stmt CF CF CF Bonds Pay Current Long-term Non-op Operating Investing Financing Date Balance Liability Liability Income Activity Activity Jan 1, , ,000 Dec 31, ,000 45, ,545 50,000 (50,000) 0 0 Dec 31, ,000 45, ,545 50,000 (50,000) 0 0 Dec 31, ,000 45, ,545 50,000 (50,000) 0 0 Dec 31, ,000 45, ,545 50,000 (50,000) 0 0 Dec 31, ,000 45, ,545 50,000 (50,000) 0 0 Dec 31, , , ,000 (50,000) 0 0 Dec 31, , ,000 (50,000) 0 (500,000) Example 2 bonds issued at discount. The only variable changing now is that when Albrecht Company takes the 10% bonds to the market, the market requires a 11% rate of return. When the original market rate of interest is higher than the stated, the proceeds will be less than the maturity value. This is because a 10% return provided by the bond is not attractive to investors wanting an 11% rate of return. When the proceeds are less than the maturity value, the bonds are said to have been sold at a discount. The complete fact situation is now: The Albrecht Company is planning to go to the financial market system to raise capital by selling 500 bonds of $1,000 denomination. The planned date of sale is January 1, The bonds mature in seven years, on December 31, The bonds have a coupon rate of 10%, and coupon interest is paid annually on each December 31. When the bonds are sold, the company has a true market tested rate of interest of 11%. 118

5 Spreadsheet input table Calculator values Maturity value (FV) $500,000 PV? =!$476,439 Coupon (stated) interest rate % FV.... $500,000 Yield (effective) interest rate... 11% I Years N Payments per year PMT.... $50,000 Total # coupon payments Type end Total coupon pmt amount.. $50,000 Type of Annuity (end=0) Proceeds $476,439 In the amortization table, there are two matters to note. The first is that the carrying value for the bond increases, from the discounted value up to the maturity value. The second is that any adjustment needed for rounding MUST BE made to interest expense, not the amount of cash payment. Cash Interest Bonds Pay Date Payment Expense Amort Balance Jan 1, ,439 Dec 31, ,000 52,408 2, ,847 Dec 31, ,000 52,673 2, ,520 Dec 31, ,000 52,967 2, ,487 Dec 31, ,000 53,294 3, ,781 Dec 31, ,000 53,656 3, ,437 Dec 31, ,000 54,058 4, ,495 Dec 31, ,000 54,505 4, ,000 The journal entries are fairly straight-forward, just like the accounting for an interest-bearing loan. Notice that Bonds Payable is debited when making a coupon payment. This is because the cash payment is not enough to pay for interest expense (the effective rate is higher than the coupon rate), and the unpaid interest amount is added to the carrying value for the bond. 1/1/2014 Cash 476,439 Bonds Payable 476,439 12/31/2014 Interest Expense 52,408 Bonds Payable 2,408 Cash 50,000 12/31/2020 Interest Expense 54,505 Bonds Payable 4,505 Cash 50,000 Bonds Payable 500,000 Cash 500,

6 Determining amounts for the financial statements follows the procedures covered in the accounting for loans, with one exception. The amount for cash flows from operating activities is always the amount for the cash interest payment. Inc Stmt Stmt CF Stmt CF Stmt CF Bonds Pay Current Long-term Non-op Operating Investing Financing Date Balance Liability Liability Income Activity Activity Activity Jan 1, , ,439 Dec 31, ,847 45, ,802 52,408 (50,000) 0 0 Dec 31, ,520 45, ,475 52,673 (50,000) 0 0 Dec 31, ,487 45, ,442 52,967 (50,000) 0 0 Dec 31, ,781 45, ,736 53,294 (50,000) 0 0 Dec 31, ,437 45, ,392 53,656 (50,000) 0 0 Dec 31, , , ,058 (50,000) 0 0 Dec 31, , ,505 (50,000) 0 (500,000) Example 3 bonds issued at premium. The only variable changing now is that when Albrecht Company takes the 10% bonds to the market, the market requires a 9% rate of return. When the original market rate of interest is higher than the stated, the proceeds will be more than the maturity value. This is because a 10% return provided by the bond is relatively attractive to investors expecting an 9% rate of return, so they are willing to bid more to buy the bonds. When the proceeds are more than the maturity value, the bonds are said to have been sold at a premium. The complete fact situation is now: The Albrecht Company is planning to go to the financial market system to raise capital by selling 500 bonds of $1,000 denomination. The planned date of sale is January 1, The bonds mature in 7 years, on December 31, The bonds have a coupon rate of 10%, and coupon interest is paid annually on each December 31. When the bonds are sold, the company has a true market tested rate of interest of 9%. Spreadsheet input table Calculator values Maturity $500,000 PV? =!$525,165 Coupon (stated) interest rate % FV.... $500,000 Yield (effective) interest rate.... 9% I Years N Payments per year PMT.... $50,000 Total # coupon payments Type end Total coupon pmt amount.. $50,000 Type of Annuity (end=0) Proceeds $525,

7 In the amortization table, there are two matters to note. The first is that the carrying value for the bond decreases, from the premium value down to the maturity value. The second is that any adjustment needed for rounding MUST BE made to interest expense, not the amount of cash payment. Cash Interest Bonds Pay Date Payment Expense Amort Balance Jan 1, ,165 Dec 31, ,000 47,265 (2,735) 522,430 Dec 31, ,000 47,019 (2,981) 519,449 Dec 31, ,000 46,750 (3,250) 516,199 Dec 31, ,000 46,458 (3,542) 512,657 Dec 31, ,000 46,139 (3,861) 508,796 Dec 31, ,000 45,792 (4,208) 504,588 Dec 31, ,000 45,412 (4,588) 500,000 The journal entries are fairly straight-forward, just like the accounting for an interest-bearing loan. Notice that Bonds Payable is debited when making a coupon payment. This is because the cash payment is more than enough to pay for interest expense (the effective rate is higher than the coupon rate), and the principle reduction is subtracted from the carrying value for the bond. 1/1/2014 Cash 525,165 Bonds Payable 525,165 12/31/2014 Interest Expense 47,265 Bonds Payable 2,735 Cash 50,000 12/31/2020 Interest Expense 45,412 Bonds Payable 4,588 Cash 50,000 Bonds Payable 500,000 Cash 500,000 Determining amounts for the financial statements follows the procedures covered in the accounting for loans, with one exception. The amount for cash flows from operating activities is always the amount for the cash interest payment. 121

8 Inc Stmt Stmt CF Stmt CF Stmt CF Bonds Pay Current Long-term Non-op Operating Investing Financing Date Balance Liability Liability Income Activity Activity Activity Jan 1, , ,165 Dec 31, ,430 45, ,558 47,625 (50,000) 0 0 Dec 31, ,449 45, ,577 47,019 (50,000) 0 0 Dec 31, ,199 45, ,327 46,750 (50,000) 0 0 Dec 31, ,657 45, ,785 46,458 (50,000) 0 0 Dec 31, ,796 45, ,924 46,139 (50,000) 0 0 Dec 31, , , ,792 (50,000) 0 0 Dec 31, , ,412 (50,000) 0 (500,000) 2 Accounting for bonds issued in a series When a corporation borrows by selling a large amount of bonds, it agrees to a daunting repayment task of making a single, very large final payment to retire the entire maturity value of the bond issue. To alleviate this stress on cash flow management, a corporation can issue bonds in a series. In this case, the entire maturity value comes due not at once, but in small amounts staggered over years. For example, let s say that on January 1, 2007, a company wants to raise capital by issuing 10% bonds (annual coupons) for $300,000, eventually to be repaid over five years. As opposed to a single maturity of $300,000 on December 31, 2011 (five years), the company chooses a series of $100,000 bond issues with the maturity dates falling December 31, 2009 (three years), December 31, 2010 (four years), and December 31, 2011 (five years). Moreover, the bonds will be issued when the market rate for similar debt is 12%. For the first bond issue, the corporation is obligating itself to make a principal repayment of $100,000 on December 31, 2009, and cash interest payments of $10,000 at year end on 12/31/07, 12/31/08, and 12/31/09. The following time line summarizes these cash flows $10,000 $10,000 $10,000 $100, /1/07 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 For the second bond issue, the corporation is obligating itself to make a principal repayment of $100,000 on December 31, 2010, and cash interest payments of $10,000 at year end on 12/31/07, 12/31/08, 12/31/09 and 12/31/10. The following time line summarizes these cash flows $10,000 $10,000 $10,000 $10,000 $100, /1/07 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 122

9 For the final bond issue, the corporation is obligating itself to make a principal repayment of $100,000 on December 31, 2011, and cash interest payments of $10,000 at year end on 12/31/07, 12/31/08, 12/31/09, 12/31/10, and 12/31/1109. The following time line summarizes these cash flows $10,000 $10,000 $10,000 $10,000 $10,000 $100, /1/07 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 When viewed in its entirety, the cash flows for the entire bond series looks like: $30,000 $30,000 $30,000 $20,000 $10,000 $100,000 $100,000 $100, /1/07 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 The first step in the accounting is to compute the bond proceeds. In this case, compute the proceeds for each issue separately, then add together. PV? = 95,196? = 93,925? = 92,790 FV 100, , ,000 N I PMT 10,000 10,000 10,000 TYPE end end end 95, , ,790 = 281,911 I am altering the bond amortization table to show separate amounts of amounts of cash paid for interest and cash paid for principal. Cash Cash Cash Interest Bonds Pay Date Interest Principal Total Expense Amort. Balance Jan 1, ,911 Dec 31, , ,000 33,829 3, ,740 Dec 31, , ,000 34,289 4, ,029 Dec 31, , , ,000 34,803 (95,197) 194,832 Dec 31, , , ,000 23,380 (96,620) 98,212 Dec 31, , , ,000 11,788 (98,212) 0 123

10 Journal entries for the entire bond issue are: 1/1/2007 Cash 281,911 Bonds Payable 281,911 12/31/2007 Interest Expense 33,829 Bonds Payable 3,829 Cash 30,000 12/31/2008 Interest Expense 34,289 Bonds Payable 4,289 Cash 30,000 12/31/2009 Interest Expense 34,803 Bonds Payable 4,803 Cash 30,000 Bond Payable 100,000 Cash 100,000 12/31/2010 Interest Expense 23,380 Bonds Payable 3,380 Cash 20,000 Bond Payable 100,000 Cash 100,000 12/31/2011 Interest Expense 11,788 Bonds Payable 1,788 Cash 10,000 Bonds Payable 100,000 Cash 100,000 Determining amounts for the financial statements follows procedures covered previously Bonds Pay Current Long-term Operating Financing Date Balance Liability Liability Activity Activity Jan 1, , ,911 Dec 31, ,740 26, ,954 (30,000) 0 Dec 31, , , ,958 (30,000) 0 Dec 31, , ,143 87,689 (30,000) (100,000) Dec 31, ,212 98,212 0 (20,000) (100,000) Dec 31, (10,000) (100,000) Accounting for bond issue costs When a corporation raises capital by selling bonds through the primary market to investors, the services of an investment banker are needed. An investment banker has responsibilities defined by the Securities Act of It advises companies as they go through the sale of securities through the primary market. It provides a due diligence investigation so that it can certify investment s worthiness. 124

11 It recommends the price of the security. It also arranges for a network of sellers that will be contacting individual investors. Fees and commissions charged by the investment banker can amount to 10% of the bond proceeds. There are three options in accounting for these and other related fees. First, under GAAP and IFRS they can be treated as a reduction to the initial carrying value of the loan with an adjustment to the effective interest rate of the loan. Second, under IFRS they can be expensed in their entirety in the period of issue. Third, under GAAP it can be treated as an asset (labeled as a deferred charge) and expensed in a straight-line fashion over the term of the bonds. The second treatment is not frequently used, and the third treatment is being phased out under GAAP. Therefore, only the first treatment is explained in this resource. The accounting for bond issue costs will be explained using an example of issuing bonds at a premium. The Albrecht Company is planning to go to the financial market system to raise capital by selling 500 bonds of $1,000 denomination. The planned date of sale is January 1, The bonds mature in 7 years, on December 31, The bonds have a coupon rate of 10%, and coupon interest is paid annually on each December 31. When the bonds are sold, the company has a true market tested rate of interest of 9%. The investment banker receives $525,165 from investors, as computed by: Spreadsheet input table Calculator values Maturity $500,000 PV? =!$525,165 Coupon (stated) interest Rate... 10% FV.... $500,000 Years I Payments per year N Total coupon payment..... $50,000 PMT.... $50,000 Market (effective) interest Rate.. 9% Type end Type of Annuity (end=0) Proceeds $525,165 The investment banker pays the selling agents a commission for selling the bonds. It passes the cost of these commissions along to Albrecht, as well as charging fees for its services as an investment banker. The commissions and fees are deducted from the $525,165, and only $470,850 is passed along to the Albrecht Company. Albrecht s accounting for the bond issue starts with this journal entry: 1/1/2007 Cash 470,850 Bonds Payable 470,850 Next, Albrecht must compute an effective rate of interest for this bond issue. The present value is the amount received. Albrecht is still obliged to make seven annual coupon payments of $50,000 and a final repayment of maturity value of $500,000. The effective rate of interest is that interest rate that equates the present value of $470,850 to the future interest payments and maturity value. This means that from the perspective of Albrecht, the bonds were issued at a discount. That the market rate was lower than the stated rate is irrelevant. 125

12 PV!470,850 FV 500,000 N 7 I? = % PMT 50,000 TYPE end In the amortization table, there are three matters to note. The first is that the initial carrying value for the bond is $470,850 (the net proceeds from the investment banker). Second, an effective rate of % is used (not the original market rate of 9% interest). Third, the carrying value of the bonds increases, from the net discounted value down to the maturity value. Cash Interest Bonds Pay Date Payment Expense Amort Balance Jan 1, ,850 Dec 31, ,000 52,957 2, ,807 Dec 31, ,000 53,290 3, ,097 Dec 31, ,000 53,660 3, ,757 Dec 31, ,000 54,071 4, ,828 Dec 31, ,000 54,529 4, ,357 Dec 31, ,000 55,038 5, ,395 Dec 31, ,000 55,605 5, ,000 Journal entries and the amounts needed for financial statements are determined using standard procedures. Spreadsheet Tips for Bonds A typical bond problem for Intermediate Accounting is shown below. A table of input values is followed by the resulting amortization table. 126

13 Two spreadsheet issues are color highlighted in this example. The first issue concerns the computation of the basic bond proceeds, or the amount that investors are willing to pay to acquire this investment in bonds (highlighted in yellow). This requires the PV function. As used in the example above, the equation for generating the proceeds value (cell B1) is: =ROUND(-1*PV(B6,B5,B8,B2),0) The PV function answer is a negative number. To convert it to a positive number, the easiest solution is simply to multiply it by!1. The elements of the PV function are: Rate per compounding period, or 4.5% (B6) in this example. Total number of bond interest payments, or 3 (B5) in this example. Bond interest payment amount, or 150,000 (B8) in this example. Bond maturity value, or 3,000,000 (B2) in this example. The second issue is accounting for the inevitable rounding errors after using the ROUND function for both the proceeds computation and the column of interest expense computations. In a bond amortization table, final period interest expense (highlighted in green) is adjusted so that the bond table ends with the maturity value. As used in the example above, the equation for generating the final period interest expense (cell C14) is: =(B2-E13)+B14 The final interest expense is equal to the amount needed to build the bond proceeds up to the maturity value (B2-E13) plus the interest payment (B14). 127

14 MS Excel (or any spreadsheet program, for that matter), can be very helpful when calculating the company proceeds net of the investment banker fee. Continuing the previous example, if the investment banker fee is 20%, then the net proceeds to the company are $2,432,987. To continue working the problem, an effective interest rate needs to be computed. In cell E6, the RATE function is used to compute the accounting effective rate. The composition is, =RATE(#periods, payment, proceeds, maturity value). The proceeds cell needs to be a negative value. In this spreadsheet example, the rate function is: =RATE(E5,E8,-E1,E2) This computed interest rate is now used to compute annual interest expense (cells C12 and C13) Accounting for bonds when bond periods do not align with accounting period Not yet written. Coming next semester? 128