Topic 5 - Accounting for Equity and Debt Debentures

Question 1

What are debentures/bonds?

Answer 1

A written promise:

• to (re-)pay a principal amount at a specific point in time
• to pay a specific rate of interest for a specific duration
• they are often secured through the “attachment” of assets to the debenture/bond

Question 2

Debentures/bonds can be issued (sold) at:

par, a discount, a premium.

Define these terms.

Answer 2

at par: sales price = face value of debenture/bond

at a discount: sales price is less than the face value

at a premium: purchaser pays more than the face value

Question 3

Differentiate between the coupon rate and the market rate.

Answer 3

coupon rate

is the rate of return (interest rate) printed on the debenture

market rate

is the rate of return (interest rate) that financial market participants require to invest in a debenture/bond of a given level of risk

• not always the same, but
• if the coupon rate = the market rate = at par

Question 4

Differentiate between the face value and the fair value.

Answer 4

face value

is the amount (principle) that is printed on the debenture

fair value

is the price that financial market participants are prepared to pay for a debenture with a given level of risk and return

• not always the same

Question 5

How are debentures valued when they are issued at par?

Answer 5

sales price = face value of debenture

coupon rate = market rate

fair value = face value (of debenture)

Question 6

How are debentures valued when they are issued at a discount?

Answer 6

sales price < face value

coupon rate < market rate

fair value < face value (of debenture)

• at the end of the debenture period, we have to pay more than the sales price

Question 7

How are debentures valued when they are issued at a premium?

Answer 7

sales price > face value

coupon rate > market rate

fair value > face value (of debenture)

• at the end of the debenture period, we have to pay less than the sales price

Question 8

Regardless of the “type” of issue (at par, discount, premium), purchasers ALWAYS receive:

Answer 8

• (re-)payment of the principal equal to the face value (amount printed)
• interest payments which are calculated:

coupon rate x face value of the debenture

Question 9

Why must discounts/premiums be recognised in financial accounting?

Answer 9

Because the returns are fixed:

issue (sales) price must always be equal to the present value of future cash flows associated with the debenture/bond

Question 10

What are the three steps needed to calculate the present value of future cash flows of a debenture/bond issued at discount or at a premium?

Answer 10

1. Determine what kind of future cash flows are associated with the debenture/bond, e.g. discount or premium?
2. Always discount future cash flows using the market rate of return:

• one-off payment discounting for repayment of principle
• annuity discounting for regular payments of interest
  1. The total present value of cash flows = issue price of the debenture/bond

Question 11

An entity issues a $1 million (face value), 10-year debenture with a coupon rate of 10% per year in a private placement. Expected market returns for this type of investment are 8%.

Calculate the present value of payments.

Next, write the journal entries for:

(1) the initial recognition of the debenture
(2) the recognition of interest payment

Answer 11

• the effective interest is different from the interest we pay
• for the recognition of interest payment, the first step is to bring down $1,134,201.63 (DR Debenture Liability) to $1 million

Question 12

An entity issues a $1 million (face value), 10-year debenture with a coupon rate of 10% per year in a private placement. Expected market returns for this type of investment are 12%.

Calculate the present value of payments.

Next, write the journal entries for:

(1) the initial recognition of the debenture
(2) the recognition of interest payment

Answer 12

• for the recognition of interest payment, the first step is to add a little to the issue price (CR Debenture Liability), so that in the end, it is $1 million

Question 13

Discounts/premiums are assigned to the time periods covered by the debenture/bond.

What are the allocations based on?

How is:

• effective interest rate
• coupon rate
• reduction of discount/premium

calculated?

Answer 13

Allocations are based on the effective interest method:

• Effective interest is calculated as:

opening liability of debenture at the beginning of liability x market rate of return = effective interest

• Coupon rate is calculated as:

face value of debenture x coupon rate of return = payment made

• Reduction of discount or premium is calculated as:

total effective interest minus payment made

• if negative, the premium is reduced (DR to debenture)
• if positive, the discount is reduced (CR to debenture)

Question 14

Write the journal entries for:

(1) the private issue of debentures/bonds
(2) the public issue of debentures/bonds

Answer 14

For the public issue of debentures/bonds:

• DR Bank Trust (until the company issues the debentures)
• CR Debenture Applications (a liability account)