F4 - M4 - Bonds: Part 1

Question 1

For bond payments, what is the formula to determine the cash that is paid to investors?

Answer 1

Par value of the bond * Coupon rate or the interest rate = Cash Payment

This is an operating cashflow item on the statement of cashflows.

Question 2

What is the formula to calculate the interest expense?

Answer 2

This is the carrying value of the bond (beginning) * Market rate (at issuance) = Interest expense

Question 3

Will the interest expense for a bond match the cash payment that was made to investors?

Answer 3

It depends, if the bond is at par, then yes.

If there is a discount or premium, then the amounts paid and the interest expense will differ.

Question 4

What does it mean when a bond is sold at a discount?

Answer 4

That means that the price of the bond is sold at a lessor price, because the stated rate is less than the market rate.

So if you are offering a rate of 8%, but the market rate is 10%, that means you are getting less coupon amounts than what the market is providing. For that reason, the bond is sold for less money, since the rate is less.

Question 5

What does it mean when a bond is sold at a premium?

Answer 5

That means that the price of the bond is sold at a greater price, because the stated rate is more than the market rate.

So if you are offering a rate of 10%, but the market rate is 8%, that means you are getting more coupon amounts than what the market is providing. For that reason, the bond is sold for more money, since the rate is higher.

Question 6

When it comes to bonds, what are the way that issuing corporations pay investors?

Answer 6

First they pay fixed interest payments which are normally semiannually - These are ordinary annuities, and will use that rate for calculating the present value.

Specific sum of money at the maturity date - This is the one time payment, so the lump sum amount will be used to calculate the present value.

Question 7

What are convertible bonds? What are nondetachable and detachable warrants?

Answer 7

Convertible bonds - These are bonds that are convertible into common stock of the debtor at the option of the bondholder.

Nondetachable warrants - The convertible bond itself must be converted into capital stock.

Detachable warrants - The bond is not given up 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. Basically they can keep the bonds and get coupon payments.

Question 8

What are participating bonds?

Answer 8

Basically, if certain income levels are obtained, they can get more income, outside of the coupon payments and payment at maturity.

Same with income bonds.

Question 9

What are term bonds?

Answer 9

This is what we are focusing on, have a fixed maturity date where the entire principal is paid at the end of this term/bond.

Question 10

When a premium occurs, that means the bond sells for more than par value. Is this a gain? Can it be booked right away?

Answer 10

This is a gain, but you cannot book it right away. The excess of the face value is called an unamortized premium, and will be amortized over the life of the bond.

Carrying value is the face value + the unamortized premium

Question 11

When a discount occurs, that means the bond sells for less than par value. Is this a loss? Can it be booked right away?

Answer 11

This is a loss, but you cannot book it right away. The face value minus the selling price gives you your unamortized discount, and will be amortized over the life of the bond.

Loss will be recorded over the life of the bond, and interest expense is greater than the coupon paid.

Question 12

Are bonds payable recorded at the face value on the balance sheet?

Answer 12

Yes, and with either subtract the unamortized discount or add the unamortized premium to adjust to the present value.

At maturity you prepay the face value, when done amortizing a premium or discount, the carrying value will actually be the face value at maturity.

Question 13

When a bond is issued at par value, what does that mean?

Answer 13

The selling price = Face value

Coupon rate = market rate

Interest expense will equal the coupon payment. Remember, interest expense is on the income statement, and coupon payments are on the statement of cash flows.

Question 14

For a bond, what are the two things that you have to calculate to get the present value?

Answer 14

You have to get the present value of the lump sum that will be calculated at maturity.

You also have to get the present value of the coupon payments which is an annuity.

Question 15

When finding the present value factor, do you use the coupon rate or the market rate?

Answer 15

Always use the market rate for present value factors. This when you find the PV for both the single lump sum and the annuity.

Question 16

What is the coupon rate used for?

Answer 16

To find the periodic coupon payment.

Face value * coupon rate = periodic coupon payment

Question 17

When the borrower of a bond gets the money, what is the journal entry to record the bond amount at par?

What about the investor?

Answer 17

Journal entry for the borrower

Debit Cash

Credit Bond Payable

Journal entry for the investor

Debit Investment in bonds

Credit Cash

Question 18

When the borrower of a bond gets the money, what is the journal entry to record the bond amount at discount?

What about the investor?

Answer 18

For borrower

DR Cash

DR Discount on bond payable - Contra Liability

CR Bond payable

For investor

DR Investment in bonds

CR Cash

Question 19

When the borrower of a bond gets the money, what is the journal entry to record the bond amount at a premium?

What about the investor?

Answer 19

For borrower

DR Cash

CR Premium on bond payable - Regular liability

CR Bond payable

For investor

DR Investment in bonds

CR Cash

Question 20

What is the stated interest rate or the coupon rate?

Answer 20

This dictates the periodic coupon payment and is an operating outflow on the statement of cash flows.

Question 21

What is the effective interest rate or market rate?

Answer 21

Dictates the selling price and proceeds of the sale, which determines the present value factors.

Also determines the interest expense on the income statement.

Question 22

Is the interest expense greater than the coupon payment for discounts? What about for premiums?

Answer 22

Yes interest expense will be greater than the coupon payment for discounts, and will be less than the coupon payment for premiums.

Question 23

How do you account for bond issuance costs?

Answer 23

They are subtracted from the face value to arrive at a reduced initial carrying value.

They are amortized as interest expense over the life of the bond to adhere to the matching principle.

Question 24

What are some examples of bond issuance costs?

Answer 24

Legal fees, accounting fees, underwriting commissions, and printing.

These are a direct reduction to the carrying amount of the bonds similar to bond discounts, and they are amortized over the life of the bond.

Question 25

When doing a bond problem, they might give you the market rate and then the effective rate. What are those and when do you use them?

Answer 25

The market rate is what you use to calculate the present factor and you always use the market rate.

The effective rate is normally the market rate with some adjustments, normally do to bond issuance costs. If this is the case and the problem gives you a market rate and a effective interest rate, you use the effective rate to find the interest expense amount.

Question 26

When a borrower pre pays the bond issuance costs before the bonds are issued, how does that work?

Answer 26

When you prepay before the bonds are issued, you make the entry below:

DR Deferred bond issuance costs

CR Cash

When the bond are eventually issued you credit bond issuance costs.