As I tutor
students in Intermediate Accounting, I find that accounting for bonds is a
tough area. That’s because the topic is not explained well- particularly
premiums and discounts on bonds. I hope this series of blog postings helps.
Bonds Defined:
I’ll limit this
discussion to corporate bonds. A corporation issues a bond. A bond is a debt
instrument. So, the corporation promises to pay interest annually, and to repay
the principal amount (the original amount issued) at maturity.
Bond Terms:
Face amount: The dollar amount of the bond when it is issued.
Corporate bonds are issued in increments of $1,000.
Interest rate: The percentage of the face amount that is paid as
interest income to the owner for the bond. Corporate bonds typically pay
interest semi-annually (twice a year).
Issuer: The corporation that sells the bond to the public.
Maturity date: The date that the issuer repays the face amount to
the bond buyer.
The complication- bond premiums and
discounts:
Assume a bond is issued for
$1,000. Bonds trade in the marketplace- just like common stocks. So, it’s not
surprising that the bond prices change. Here are two terms that define bond prices:
Premium: If a bond is priced above the face amount
(above $1,000), it is priced at a premium.
Discount: If a bond is priced below the face amount
(below $1,000), it is priced at a discount.
Why would anyone buy a bond at a premium?
When I sold bonds to
customers as an investment broker, I answered this question all the time.
Assume a company issues a
$1,000 7% bond. The bond is due in 10 years (that is the maturity date is in 10
years). A few months later, interest rate fall. Now, 10 year bonds can be
issued at 6%. As an investor, you’d prefer to earn 7% than 6%. So, you’re willing
to pay more than $1,000 for the 7%. Let’s assume you’re willing to pay
$1,100.
Here’s the result: You pay
$1,100 for the bond, but only receive the face amount ($1,000) at maturity. You
lose $100. However, you earn 7% a year, instead of the 6%.
As I explained it to my bond
customers, consider the total return on the bond investment.
The technical term is yield to maturity (YTM). There are
two cash flows that make up your total return. One cash flow is the gain or
loss you incur when the bond matures (in this case, a $100 loss). The other
cash flow is the interest payments you earn each year (7%). Here’s the bottom
line: the 1% higher interest payment (7% vs. 6%) may more than offset the $100
loss at maturity.
Now the I’ve addressed
premiums at discounts, part 2 of the blog will move on to bond accounting. In
the meantime, take a look at this video for more help:
http://www.youtube.com/watch?v=FdwXvHDMUwg
Your comments are welcome! For live chats on
some of the toughest accounting topics, go to my website listed below.
Thanks!
Ken Boyd
St. Louis Test Preparation
(cell) (314) 913-6529
(you
tube channel) kenboydstl
(blog) http://accountingaccidentally.blogspot.com/
(twitter)
@StLouisTestPrep
Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013
A very important factor of accounting is the creation if budgets. Budgets are essential as they outline what is needed for various areas of a business such as advertising, hiring staff, materials etc.
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