Bonds and Present Value Tables Flashcards
What is a bond?
A borrowing agreement in which the issuer promises to repay a certain amount of money (Face/Par Value) to the purchaser after a certain period of time (term) and at a certain interest rate (Effective, Yield, Market rate).
What is a borrowing agreement in which the issuer promises to repay a certain amount of money (Face/Par Value) to the purchaser after a certain period of time (term) and at a certain interest rate?
A bond
What is a term bond?
Any bond that matures on a single date
What are bonds that mature on a single date?
Term bonds
What is a serial bond?
Any bond in which the principal matures in installments
What are bonds in which the principal matures in installments?
Serial bonds
What is a debenture bond?
Unsecured bonds not supported by any collateral
What are unsecured bonds not supported by any collateral?
Debenture bonds
What is the stated, face, coupon, or nominal rate?
The rate printed on the bond, representing the amount of cash the investor will receive each payment
What is the rate printed on the bond, representing the amount of cash the investor will receive each payment?
The stated, face, coupon, or nominal rate of the bond
With regard to bonds, what is the carrying amount comprised of?
The net amount at which the bond is REPORTED on the balance sheet, which is the face value of the bond net of the premium (plus) or discount (minus). Also referred to as the bond’s book value or REPORTED amount.
What is the effective rate or yield of a bond?
The actual market rate of interest the company is going to pay on the bond based on the issue price. The effective rate is often called the market rate of interest or yield.
What does it mean when a bond is issued at a premium?
The prevailing effective (market) rate of interest is lower than the bond’s stated rate. Since the cash interest and principal repayment are based on face value, accordingly, the bond will yield more than what the market is offering and so it must be sold above par value (at a premium) in order to fairly compensate the seller.
What does it mean when a bond is issued at a discount?
The prevailing effective (market) rate of interest is higher than the bond’s stated rate. Since the cash interest and principal repayment are based on face value, accordingly, the bond will yield less than what the market is offering and so it must be sold below par value (at a discount) in order to fairly compensate the bond buyer/purchaser.
What is a convertible bond?
A bond that can be converted into stock
What type of bond is convertible into common stock of the debtor at the bondholders option?
A convertible bond
What is a callable bond?
A bond in which the issuer has the right to redeem prior to its maturity date
What type of bond grants the issuer the right to redeem prior to its maturity date?
A callable bond
With regard to bonds and other debts, what is a covenant?
Restrictions that borrowers must often agree to
With regard to bonds and other debts, what are the restrictions that borrowers must often agree to referred as?
Covenants
When is a bond issued at a discount?
When the bond’s stated interest rate is less than the market (effective) rate of interest
When the bond’s stated interest rate is less than the market (effective) rate of interest, is the bond issued at a discount or premium?
Discount
When is a bond issued at a premium?
When the bond’s stated interest rate is greater than the market (effective) rate of interest
When the bond’s stated interest rate is greater than the market (effective) rate of interest, is the bond issued at a discount or premium?
Premium
Can the fair value method be elected for bonds?
Yes
What is the present value of a bond comprised of? (i.e., how are the proceeds from a bond sale calculated?)
1) Present value of the face AMOUNT (lump sum)
2) Present value of the annuity (periodic interest payments)
What do the present value of a bond’s lump sum payment and the present value of its periodic interest payments combine to become?
The present value of the bond (as a whole)
What is the difference between a regular annuity and an annuity due?
A regular annuity’s payments are made at the end of the payment period, while the annuity due’s payments are made at the beginning of the period (like rent/mortgage interest)
How are annual interest calculations adjusted for semi-annual payments/compounding?
Multiply the number of years by 2 and divide the interest rate in half
What is the present value of an amount (lump sum) used to determine?
Used to determine the equivalent value today of a single cash flow that will occur at a future date
What time value of money calculation is used to determine the equivalent value today of the payment of a single ash flow that will occur at a future date?
Present Value of an Amount
What does the present value of an ordinary annuity refer to?
Used to determine the equivalent value today of repeated cash flows on a systematic basis, with amounts being paid at the end of each period
What time value of money calculation is used to determine the equivalent value today of repeated cash flows on a systematic basis, with amounts being paid at the end of each period?
Present Value of an Annuity
What does the present value of an annuity due refer to?
Used to determine the equivalent value today of repeated cash flows on a systematic basis, with amounts being paid at the beginning of each period
What time value of money calculation is used to determine the equivalent value today of repeated cash flows on a systematic basis, with amounts being paid at the beginning of each period?
Present Value of an Annuity Due
What do the future values from compounding interest refer to?
These look at cash flows and project them to some future date, and include all three variations applicable to present values (amount, ordinary annuity, annuity due)
What is an easy way to convert from the present value of an ordinary annuity interest factor to the interest factor for the present value of an annuity due (and vice versa)?
Simply add 1 ($1 upfront doesn’t require any discounting) to the interest factor for the present value of an ordinary annuity from the prior period (so a 4 year interest factor from the ordinary annuity will become the 5 year interest factor for the annuity due). Conversely, subtract 1 from the present value of an annuity due’s interest factor from the following period to arrive at the present value of an ordinary annuity.
When calculating the present value of a bond, what interest rate is used for both present value calculations?
The market (effective) interest rate, NOT the stated interest rate
What is the journal entry for a bond at issuance?
Dr. Cash (% face/PV calculation + accrued interest - BIC) Dr. BIC (Bond Issue Costs) Dr. Discount (plug) Cr. Premium (plug) Cr. Bond Payable (Face Amount) Cr. Accrued Interest Payable
What type of costs constitute Bond Issue Costs (BIC)?
Any costs directly associated with the issuance of the bonds, such as:
1) Printing and engraving of the bond certificates
2) Legal and accounting fees
3) Underwriter commissions
4) Promotion costs (printing of prospectus)
What financial statement element are Bond Issue Costs (BIC)?
Non-current assets (specifically a deferred charge)
How are Bond Issue Costs (BIC) amortized?
Straight line over the period of time the bonds are outstanding
Are Bond Issue Costs (BIC) included in the carrying value of bonds?
No! The main giveaway is that these non-current assets are amortized straight-line over their useful lives as opposed to the Effective Interest Method for bonds.
With regard to bond issuance, what is the only component where straight-line amortization is permitted under GAAP?
Bond Issue Costs
Is straight-line amortization of bond discounts or premiums permitted under GAAP?
No!
What method of amortizing bond discounts or premiums is permitted under GAAP?
Effective Interest Method
How does a bond’s recorded value differ from its reported value?
The recorded value is simply the initial value of the bond, whereas the reported value is effectively the carrying value which includes the value of the bond net of its discount or premium
Are bond discounts and premiums current or non-current liability valuation accounts?
They are NON-CURRENT liability valuation accounts
When amortizing a discount, what happens to interest expense? What happens to the amortization of the discount?
The interest expense increases each year; thus, increasing the amortization of the discount each successive year
When amortizing a premium, what happens to interest expense? What happens to the amortization of the premium?
The interest expense decreases each year, but this causes the amortization of the premium to increase each successive year
What is the journal entry for a bond called or retired prior to maturity?
*A gain or loss on the early retirement is inserted into a reversal of the journal entry of the bond at issuance: Dr. Bonds Payable (face) Dr. Premium (unamortized) Dr. Loss (plug) Cr. Gain (plug) Cr. BIC Cr. Discount Cr. Cash (amount to retire)
How is the retirement of bonds recorded?
Gain or Loss is Ordinary
Extraordinary if both unusual and infrequent
Are the gains or losses stemming from the early retirement of bonds prior to maturity classified as part of continuing operations or are they to be treated as extraordinary items, net of taxes?
It really boils down to whether the gain or loss is deemed to be unusual and infrequent, which would cause them to be reported in extraordinary items, net of taxes.
What is a fund set up for the retirement of bonds referred as?
Bond sinking fund
What is a bond sinking fund?
A fund set aside specifically for the repayment/retirement of bonds at maturity
Are bond sinking funds considered part of cash?
No, they are a noncurrent asset until the bonds mature.
How are interest or dividends earned by a bond sinking fund recognized?
They are recognized as other operating income and added to the sinking fund balance
When calculating the amortization of the bond’s discount or premium, what interest rate is used for the calculation?
The market (effective) interest rate, NOT the stated interest rate
How is the amortization of the bond’s discount or premium calculated?
Using the effective interest method which consists of the two steps:
1) Carrying value (face +/- discount/premium) x Effective Interest (Market) Rate = Interest Expense
2) Interest Expense - regular bond cash payment (face x stated rate x time) = Amortization of discount or premium
Are convertible bonds more likely to be issued at a premium or discount?
A premium, given the convertibility feature.
Which recording method is used for convertible bonds?
Book value method used if no gain or loss
Market value method used if there is a gain or loss
Describe the book value method when converting from bonds to stocks.
No gain or loss is recognized: Dr. Bonds Payable (face) Dr. Premium Cr. BIC Cr. Common Stock (par value) Cr. APIC (this is the plug for the difference between the Bond's Book Value and the Par Value of the Common Stock)
Describe the market value method when converting from bonds to stocks.
A gain or loss is recognized: Dr. Bonds Payable (face) Dr. Premium Dr. Loss (plug) Cr. Gain (plug) Cr. BIC Cr. Common Stock (par value) Cr. APIC (this difference between the Bond's Book Value and the Par Value of the Common Stock is given)
Distinguish between which method of converting bonds to stocks is GAAP compliant and not.
The book value method (no gain or loss, APIC plug) is GAAP compliant, while the market value method is non-GAAP.
What type of bond is akin to issuing two securities?
Bonds with Detachable Stock Purchase Warrants
Assuming the bond and warrant FMVs are known, what method/approach is used to distinguish between the two securities when a bond with detachable stock purchase warrants is issued?
The relative fair market value approach (just like with land and building from PP&E/Fixed Assets)
How are bonds that include non-detachable stock purchase warrants valued?
No separate value is given for the non-detachable warrant and the security is valued as a whole.
Regarding bonds with detachable stock purchase warrants, is the bond component more likely to be issued at a premium or discount?
They will be issued at a discount. Use the relative fair market approach to help determine the discount. This is a common error!
Assuming only one of the bond and warrant FMVs are known, what method/approach is used to distinguish between the two securities when a bond with detachable stock purchase warrants is issued?
The security whose value is not know is simply plugged.
Regarding bonds with detachable stock purchase warrants, what happens when the warrants expire?
They are closed out into APIC
How are bonds with detachable stock purchase warrants recognized?
Dr. Cash
Dr. Discount
Cr. Bonds Payable
Cr. APIC – Warrants
What disclosures are typically required for bonds?
The combined aggregate amount of maturities and sinking fund requirements for all long-term borrowings for each of the next 5 years and in the aggregate are required.
When does interest expense start accruing on a bond?
When the bonds are issued
How is an interest payment on a bond calculated?
Cash for payment : Stated rate x Face amount
What amount of interest is expensed on a bond interest payment?
Interest expense : effective yield x carrying value
Any difference between expense and cash payment is applied as amortization against premium/discount
Under IFRS, bonds are accounted for at what cost? Using what method?
They are accounted for at amortized cost using the effective interest method (same as GAAP)
Under IFRS, how are compound instruments such as convertible bonds treated?
They are separated into their liability and equity components
Under IFRS, is the fair value method for accounting for bonds permitted?
Yes. It is referred to as Fair Value Through Profit or Loss (FVTPL)
What is meant by the par value of a bond?
Par value is the stated or face value of the bond without any discounts or premiums
What are stock warrants?
Option contracts that are issued with, and are usually detachable from, bonds and notes that grant the bondholder the right to buy the stock at a fixed price within a specific time period.
