Now, let's move to the discussion of accounting procedures
for bonds, for long-term liabilities.
Well, we talked about bonds a great deal,
both in our capital markets course and our corporate finance course.
So here, I will use two episodes.
In the first, I will recall or recap some of the things that we should know.
And then in the next episode,
we will make some progress because accounting for long-term bonds is somewhat special.
What do we know about bonds?
We know that they're public investments
or better to say public debt because you can say investments are assets.
While here, it depends upon whose side it would take.
For investors who buy them,
they're investments and for a company that issues them,
this is a liability.
But this is public debt.
Then, we know that it has no collateral,
but it has a liquid market.
So the main idea is that,
people lend to the company publicly because,
although they do not enjoy collateral,
but they see that they can always get
out of this investment by selling the bond on the market.
Now basically, companies they issue bonds to
finance their projects and this way they accept long-term liabilities.
The next thing is,
what parameters do bonds have?
Again, you should know all that.
First of all, this is the face value that is normally $1,000.
This is the amount that the company pays at the moment that the bond matures.
So the next thing clearly is maturity.
This is for how many years it lives.
And then finally, the next thing is coupon,
this is the rate, and normally,
its semi-annual in the U.S. at least,
and this is the interest that the bond pays.
And if for example this is 10 percent,
that means that the investor receives $50 each six months.
Now, we remember that to study bonds,
we have to use the PV approach,
and therefore, when we issue them,
we sell them not necessarily at par.
So we can say the next thing that bonds can be issued at par,
this happens when the coupon rate is the same as the market interest rate.
They can be issued at a premium,
this is when C is greater than R and they can be issued at
a discount when C is less
than R. And we know that the utmost example of
a discount bond although this is a short term,
this is a Treasury bill,
in which coupons are just non-existent.
So you have zero coupon,
so these are discount bonds.
And now there exists discount bonds for longer periods of time,
so it falls within the scope of this discussion.
And we said that because of that,
I will put that we are back to the famous PV idea that we
studied heavily in our corporate finance course.
And from this moment,
I will like to move on
and we will see what happens with recording.
Let's see recording.
First of all,
we have some accounts here.
We have interest expense and then when interest accrues,
we have interest payable.
This is the balance sheet account,
this is the income statement.
And then, when the interest is accrued and then clearly when we actually use cash,
then our interest payable disappears,
and then cash is being used for this payment.
Now, let's show some some cases.
Case one and case one is the most simplest,
the case is when the bond is issued at par.
And we would say that we issue
100 bonds and the coupon rate is eight percent.
Now, let's see at the moment of issue,
what transactions we record here?.
So first of all, this is cash.
The bond is issued at par,
so we receive $1 million.
Again here for simplicity,
we ignore all the fees that we might incur in this process.
And then, we create the balance sheet account, bonds payable,
this is our liability,
also in the same amount.
This is the moment of the issue.
Now, what happens in six months?
Well, and let's say that we make our accounts annually,
but that happens in six months.
We first of all have interest expense, how much is it?
It's eight percent on this par and this is semi-annual,
so this is $4,000.
And here we paid this coupon with cash,
so here comes cash $4,000, that's it.
Now, what happens, let's say in 12 months less one day?
We ignore the [inaudible] this day.
What we have again?
The same interest expense, that is 4,000,
but now we have here interest payable which is 4,000.
Again, the next day what happens is then we debit interest payable and credit cash,
and we pay this out.
So far so good.
Let's see what happens?
We talked about accumulation of interest,
but at the same time we have to take a look at what happens when the bond matures.
The key story is that
the balance of the account bonds payable when the bond is still with us,
is still the same, it's $1 million.
It will be changed only at the moment of disposal.
The bond was issued at par and the cost is the same.
So, this is the key story.
In all these 20 periods, six months,12 months,
18 months and so,
we have the same balance of bonds payable.
Now, what is the final situation of
the final date?, that is maturity.
At this time, we have the final coupon payment and the principal payment.
What kind of accounts and recordings do we have?
First of all, bonds payable at this moment,
this is debited by 1 million because they mature and disappear from our accounts.
Now, we clearly have interest expense, the same 4,000.
And now for cash and interest expense,
this is also a debit like this.
And so the final payment is final coupon plus the principal, so this is 104.
This is the way that we make recordings for the bonds issued at the par [inaudible].
But most bonds are not issued at par.
And the question arises, what happens then?
And this is the promised case that we'll
study in the next episode because the idea is that,
if bonds are short term,
some of these differences in accounting, they are insignificant.
However, if you have a really long period
of maturity and then there is a significant difference between C and R,
you can see that bonds may be issued at a high premium or at a significant discount.
And the difference between this amount of
the maturity value and the amount at which you issue these bonds,
might be quite significant and it would be not right to keep the difference overtime.
Instead, overtime, we'll be seeing this discount amortized or this premium amortized,
and the cost of the bond will approach this amount.
In the next episode,
we'll talk about bond discount and bond premium amortization.
Konstantin KontorDirector and Professor of Finance and Strategy
