2.8. Bonds (2) – amortization of premium/discount

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Do curso por Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

1 rating

Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

1 rating

Curso 3 de 5 em Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

Na lição

Operational Assets. Depreciation. Short-Term Investments. Long-Term Liabilities. Shareholders’ Equity. Some Tax Issues

Week 2 is devoted to long-term assets and liabilities. We start with operational assets and see the role of depreciation and amortization in financial accounting and compare it to the way depreciation is used in valuation of investment projects. Then we discuss how financial investments in securities – stocks and bonds – are treated in accounting dependent upon goals and time horizon of holding and/or issuing of these securities. You will see how financial concepts (present values) are used in accounting for bond premium/discount amortization. Finally, an overview of the accounting approach to taxes is provided. On an example, you will study the core idea of deferred taxes.

2.1. Operational assets – types and accounting approach13:17

2.2. Depreciation11:14

2.3. Depreciation tax shield8:53

2.4. Intangible assets – accounting and amortization7:22

2.5. Short-term investments in bonds10:19

2.6. Short-term investments in stocks12:33

2.7. Bonds (1) – parameters and accounting approach10:31

2.8. Bonds (2) – amortization of premium/discount13:34

2.9. Equity (1) – accounting for common and preferred stock11:37

2.10. Equity (2) – treasury stock and stock dividends12:15

2.11. Accounting for taxes – an overview9:11

2.12. Deferred taxes – an example8:32

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, let's talk about bond premium or bond discount amortization.

Now, the situation here is as follows.

If you issue a bond, not at par,

then the amount you collect,

if we ignore all the fees,

is different from $1,000 for each bond.

And therefore, there is a difference.

Sometimes it's quite significant and the carrying value of this bond on

your account changes over time and then

approaches the maturity value at the time of maturity.

So, this process is called premium or discount amortization.

And to make it clear,

I will go ahead with some examples.

So the idea is amortization of bond premium discount.

Now, so we introduce the idea of carrying value.

So this is what shows up on our accounts after.

So basically, we placed that at how much money we collect from that at cost and then,

we change this carrying value,

and we will use an example and for this example again,

we will talk about 100 bonds issued.

And the parameters are as follows,

they're issued at a discount and first of all,

we will find what this discount is.

So, the face value for 100 bonds will be 100,000.

Now, of the maturity period will be 10 years,

that is what we sort of postulate.

And then, the coupon rate is

four percent while the market rate is six percent.

So, we can see that C is less than R so this corresponds to a discount.

Now, we know how to calculate how much money we will collect in this process.

So we know all of the cash flows.

The first one will be coupons of the four percent a year here.

So each six months,

they're are going to be $2,000.

So, this is 20 cash flows of $2000 and then the final cash flow of $100,000.

Well, 102 with the last coupon,

and that should all be discounted at three percent,

because this is the annual rate and semi-annual will be three percent.

So if we did that,

then we can say that the issue price,

so, this is present value, will be $85,122.

Well, you can check it with the use of

your advanced knowledge of corporate finance and PV calculations.

And therefore, the amount of discount,

this is the difference between the face value and the issue value, which is $14,878.

So, this amount should be amortized.

How can we do that?

Well, we'll study two methods.

The first will be a straight line amortization method,

the most simplistic but not the most accurate.

And the other one,

will be much more accurate but a little bit more cumbersome.

Alright, so let's keep this in mind and proceed.

First of all, with Case 1,

straight line amortization.

So, in this case,

the amortization charge A,

the same as for D,

when we use depreciation in our analysis of tangible assets.

That would be the overall amount of discount 14,878,

and then we divide by 20.

20 is the number of periods because again,

this is a semi-annual bond.

So ten years corresponds to 26-month periods and that is $744.

I am rounding things up.

So what do we have here?

So each six months,

we will have interest expense.

Let me put it here, interest expense,

and interest expense here will be the overall amount that consists of two parts.

So first of all, that will be 2,744.

So, 2000 is just the coupon payment.

Now here, we have cash because

this is the amount we pay out in the form of our coupon.

But then, we also introduce another account that is discount on bonds payable.

So, here we have 744 and this account,

then our new carrying value will be,

remember it was 85,122.

Now, add this and the new carrying value will be equal to 85,866.

So, the difference is this amortization of the bond discount.

So, this is simple method but the story is what is

the actual interest that we have over the first period?

So, we take this amount and divide that by 85,122.

So, we can say that the first interest,

this is about 2.35 percent.

Let's say 10th interest expense will be about 2.18 percent.

So, we can see that the interest expense,

it changes over time.

The discount doesn't.

So, that shows to you that this is an easy method.

But sort of, I'm not saying misleading but not a very

clear method because the actual effective interest rates,

they are always different here and most often,

people use another way.

That is called, here on we put a case 2.

Effective interest method.

Now, what is this method?

We say that the interest expense

is calculated at the market rate.

So, in our example,

we have the first carrying value.

So, we have $85,122.

So, we take this amount and say what is the interest expense at three percent?

That will be $2,554.

And then, we say that this amount is the discount

that is taken to account for this first period.

So, we introduce the following accounts.

Interest expense, 2,554.

Now, cash, this is the coupon paid.

This is 2,000, and then the,

now, the discount on bonds payable,

that will be 554.

So, the first one is smaller than it was. Remember it was 744.

But the thing is,

that now the new carrying value,

CV is equal to $85,676.

So, what did I do here?

This is from here and from here.

Now, so far it's not quite clear what with it but see what happens.

What happens in 12 months?

So, this is for six months.

What happens in 12 months?

And as always, less one day because we have to

introduce another account and then we'll clear things up.

So, to find the interest expense,

we take this amount and multiply that by three percent.

So, the new interest expense will be higher.

It will be 2,570.

Now, we have interest payable of 2,000.

Again, like I said,

when this day disappears,

then interest payable is paid.

So, we'll have cash and interest payable will be nothing here.

But now, the discount on bonds here, we add 570.

See what happened? The second discount is greater.

And now, you can check that the difference is exactly 50 percent.

So, this is 554 multiplied by 103.

Well, you perceived that and you see that what happens is that over time,

discount on bonds payable goes up.

And so, does the carrying value that slowly approaches the maturity value.

So, I will put some amount just before maturity.

So let me put it here, 10 years.

Now, discount will be 554 multiplied by 103 to the 19th power,

that will be $971 and we will have the following interests here.

Interest expense, 2,971.

Now, interest payable, 2,000.

And then, discount on bonds payable 971.

And then, the next day when bonds mature,

so this is 10 years less one day.

So, this is our final entry.

So, we will have interest payable debited by 2,000.

Now, bonds payable, because by that time,

the bond carrying value,

it will actually reach $100,000.

And then, we will credit and here will be cash for the final payment of 102.

So, the story is that although this process seems to be a little bit more cumbersome,

but the effective interest method means that

the interest expense for each period is calculated

as the carrying value over balance of the bonds.

At the beginning of this period,

and then, you use the market rate.

So, this is sort of the more,

let's say natural method.

Although, this is kind of cumbersome.

If we issued the bond at a premium,

then the amount will be higher than the 100,000,

and we will have a premium on bonds payable.

It will be on the other side and the story will be exactly the same.

You have some examples in your assignments.

And here, I am wrapping this up and then

the next two episodes will say a few words about shareholders equity.

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