Debt is classified as short-term (ST) and long-term (LT).
Below we will focus on debt resulting from financing activities.
Bond premiums and discounts:
At the time of issuance, the firm receives proceeds from issuing the bond. A bond payable is valued at the present value of its future cash flows (periodic coupon payments and principal repayment at maturity). These cash flows are discounted at the market rate of interest at issuance. Therefore, the value of the bond depends on the market rate of interest. For example, if the market rate of interest is higher than the coupon rate, the bond value will be less than its face value, and the bond is issued at a discount.
At the end of each semi-annual payment period, the firm makes a coupon payment:
The bond premium or discount is amortized over the life of the bond by what is known as the interest method. This results in a constant rate of interest (not a constant interest expense) over the life of the bond. Bond interest expense is increased by amortization of a discount and decreased by amortization of a premium.
At any point in time the liability on the balance sheet will equal the present value of the remaining cash flow payments to the creditor discounted at the effective market interest rate.
At the maturity date, the firm repays the face value of the bond. The treatment and effects of the last coupon payment are the same as those shown above.
Total interest expense is equal to amounts paid by the issuer to the creditor in excess of the amount received.
Summary of the Effective Interest Method
This method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. Since the percentage is the effective rate of interest incurred by the borrower at the time of issuance, the effective interest method results in a better matching of expense with revenues than the straight-line method.
Evermaster Corporation issued $100,000 of 8% term bonds on January 1, 2015, due on January 1, 2020, with interest payable each July 1 and January 1. Since investors required an effective interest rate of 10%, they paid $92,278 for the $100,000 of bonds, creating a $7722 discount.
1. To record the issuance:
2. To record the first interest payment of $4,000 on July 1, 2015:
Note: 92,278 x 0.10 x 0.5 = $4,614. Now the discount balance is 7,722 - 614 = $7,108.
3. To record the second interest payment of $4,000 on January 1, 2016:
Note: (100,000 - 7,108) x 0.10 x 0.5 = $4,645. Now the discount balance is 7,108 - 645 = $6,463.
And so on.
Zero-coupon bond has no periodic interest payments and is issued at a large discount from par. The proceeds at issuance equal the present value of the face value, discounted at the market value of interest at issuance. Repayment at maturity includes all the (implied) interest expense (equal to face value minus the proceeds) from the time of issuance: Total Implied Interest = Par Value - Proceeds Received.
In essence, zero-coupon bonds are a special type of discount bonds. Therefore, their effects on financial statements are similar to those of discount bonds.
For example, assume a market interest rate of 5%, a $100,000 face value zero-coupon bond payable in three years will be issued at $86,229.68 (semi-annual compounding). This is computed by pressing the following calculator keys: 100000 FV; 2.5I/Y; 6N; CPT PV.
The journal entry (of the issuer) to record this issue will be:
When the bond is paid at maturity, the repayment of $100,000 includes $13,770.32 of interest. The major difference between a zero-coupon and a par value bond is that the interest of $13,770.32 is never reported as a cash flow from operations for a zero-coupon bond.
This is because the full $100,000 is reported as a cash flow from financing.
|teddajr: if MR > CR => PRM else if CR > MR => DISC|
| leo6fin: I think its the other way around|
if MR > CR => DISC else MR < CR => PRM
| fanfanli: Can someone explain why an inflow of cash, is accounted for as a Debit here. |
Would this not be a credit to the asset side (cash) and a credit to the liability side (Bond Payable).
|TMP1982: fanfanil everything must equal in the accounting equation. an addition to cash on the asset side is a debit. Debit has no negative or positive implications in accounting- just means left or right (think T diagrams). I hope this helps.|
|Nitishm: In the example above, how did they get $92278 as the amount that investors will pay for the bonds. What is the calculation to get to that figure?|
|gill15: I'm soo happy to not be taxing right now.|
|Kevdharr: Same here gill15. And Nitishm, the $92,278 is derived by calculating the present value of each coupon payment discounted at the market rate of interest (10% in this example) and adding it to the present value of the principal repayment of $100,000 (also discounted at 10%). When you add those numbers together, you should get $92,278 or something close to it.|
|degosan9: I keep doing the above calculation but I keep getting a different number. I keep getting $92418. That's five $8k payments discounted back five years at 10% and one $100k payments discounted back five years at 10%. What am I missing?|
|degosan9: Nevermind. I'm a dummy. Was doing 10% annual x 5 instead of 5% semiannual x 10|
|aguest: why CFO will decrease after coupon payment? Isn't it part of cash flow from financing (CFF)?|
|aguest: interest payments are part of CFO|