Bonds Pt. 1 Flashcards
Common bond terminology
bond indenture - the document that describes the contract between the issuer (borrower) and bond holders (lenders)
face (par) value - the total dollar amount of the bond and the basis on which periodic interest is paid; bonds are issued at face (par) value when the stated rate of interest equals the market rate of interest
stated (nominal or coupon) interest rate - the interest to be paid to the investors in cash; this rate is specified in the bond contract
market (effective) interest rate - the rate of interest actually earned by the bondholder and is the rate of return for comparable contracts on the date the bonds are issued
discount - if the market rate is higher than the stated rate, the bonds will be issued at a discount, in which case the bonds sell for less than the face amount to make up for the lower return being provided
premium - in the market rate is lower than the state rate, the bonds will be issued at a premium because the investor will pay more than face value due to the higher return offered
Types of bonds
debenture bonds - unsecured bonds
mortgage bonds - bonds that are secured by real property
collateral trust bonds - secured bonds
convertible bonds - convertible into common stock of the debtor (generally) at the option of the bondholder; if it has nondetachable warrants, the convertible bond itself must be converted into capital stock; if it has detachable warrants, the bond is not surrendered upon conversion, only the warrants plus cash representing the exercise price of the warrants; the warrants can be bought and sold separately from the bonds
participating bonds - bonds that not only have a stated rate of interest but participate in income if certain earnings levels are obtained
term bonds - bonds that have a single fixed maturity date; the entire principal is paid at the end of this term/period
serial bonds - prenumbered bonds that the issuer may call and redeem a portion by serial number (often redeemed pro rata annually/in a series of annual installments)
income bonds - bonds that only pay interest if certain income objectives are met
zero coupon bonds - bonds sold with no stated interest but rather at a discount and redeemed at the face value without periodic interest payments
commodity-backed bonds - bonds that are redeemable either in cash or a stated volume of a commodity, whichever is greater
Facts on bonds
bonds payable should be recorded as a long-term liability at face value and adjusted to the present value of their future cash outflows by either subtracting unamortized discounts or adding unamortized premiums; bonds payable are recorded at the true present value at the date of issuance based on the market (effective) interest rate at that date
when a bond is issued, the price is computed as the sum of the present value of the future principal payment plus the present value of the future periodic interest payments; both cash flows are discounted at the prevailing market rate of interest on the date of issuance; this recorded price is the value of the bond at its current cash equivalent
a bond is issued at par value when the stated rate on the bond is equal to the market (effective) interest rate on the date the bonds are issued
a bond is issued at a discount when the stated rate on the bond is less than the market (effective) interest rate on the date the bonds are issued
a bond is issued at a premium when the stated rate on the bond is greater than the market (effective) interest rate on the date the bonds are issued
the carrying value of a bond equals face plus the balance of unamortized premium or face minus the balance of unamortized discount; as bonds approach maturity, their carrying values approach face value, so that the carrying value of the bonds equals face value at maturity; the carrying value of a bond with a discount increases to maturity value as the discount is amortized; the carrying value of a bonds with premium decreases to maturity value as the premium is amortized
What are bond issuance costs?
they are transaction costs incurred when bonds are issued (legal and accounting fees, underwriting commissions, and printing); when bonds are accounted for at amortized cost, bond issuance costs are accounted for as follows:
they are presented on the balance sheet as a direct reduction to the carrying amount of the bond, similar to bond discounts
when bonds are issued, the bond proceeds are recorded net of the bond issuance costs
they are amortized as interest expense over the life of the bond using the effective interest method
bond issuance costs incurred before the issuance of the bonds are deferred on the balance sheet until the bond liability is recorded
