When a corporation wants to finance it’s operations, it has options in how to raise the money. The first is to offer stock, or equity, in the company. Another is to issue bonds. Bonds are simply a form of an interest-bearing note. Like a note, it requires periodic interest payments, and the face amount must be repaid at the date of maturity. Bondholders are creditors of the corporation, and their claims rank ahead of stockholder claims.
Characteristics and Terminology of Bonds
Corporations that issue bonds enter into a contract called a bond indenture, or trust indenture, with the bondholders. Usually the face value of each bond, called the principal, is in multiples of $1,000. The interest on bonds may be payable annually, semiannually or quarterly. Most bonds pay interest semiannually.
Prices of bonds are stated as a percentage of the face value of the bond. Investors could purchase a company’s bond quoted at 105 for $1,050. Bonds quoted at 115 would be purchased for $1,150.
When all bonds of an issue mature at the same time, they are called term bonds. If the maturities are spread over time, they are called serial bonds.
Some bonds may be exchanged for other securities such as common stock. These are called convertible bonds. If the corporation reserves the right to redeem bonds before their maturity, these bonds are called callable bonds. Bonds issued with no collateral on the basis of the general credit of the corporation are called debenture bonds.
There are three factors that determine the price that buyers are willing to pay for the bonds a corporation issues. These are the face amount of the bonds (the amount due at maturity), the periodic interest to be paid on the bonds, and the market rate of interest.
The bond indenture identifies the face amount and the periodic interest to be paid on the bonds. The periodic interest, called the contract rate or coupon rate, is expressed as a percentage of the face value of the bond.
The market rate is also known as the effective rate of interest. This is determined by a variety of factors, including the investors’ assessment of current economic conditions as well as future expectations.
If the contract rate and the market rate are equal, then the bonds sell at their face amount. If the market rate is higher than the contract rate, then the bonds sell at a discount. That means that they are selling at a rate less than their face amount. In contrast, if the market rate is lower than the contract rate, bonds sell at a premium, or higher than their face value.
The face amount of the bonds and the periodic interest rates indicate cash that is to be paid to the buyer of the bond in the future. The buyer determines how much to pay for the bond by using the market rate of interest to compute the present value of these future cash receipts. The present value concept is based on the time value concept of money.
The time value concept of money indicates that an amount of cash to be received today is worth more than the amount of cash to be received in the future. For example, if you were to receive $100 today, you could invest it and have more later. If it could be invested at 10%, then in a year you would have $110. In this example, the $100 you received today is the present value of $110 to be received a year from today. Another concept related to the time value concept is future value. In this example, $110 to be received a year from today is the future value of $100 today, assuming the 10% interest rate.
Present Value of the Face Amount of Bonds: The present value of bonds is the value today of the amount to be received at the maturity date. For example, if you are to receive the face value of a $1,000 bond in one year, and the market rate of interest is 10%, the present value of the bond is $909.09 ($1,000 divided by 1.10). If the same bond was to mature in two years, then you’d divide the $909.09 by 1.10 to get the present value of the bond, $826.45. This is assuming compound interest annually.
You can determine the present value of the face amount of bonds to be received in the future with a series of divisions. However, it is easier to use a table of present values. The present value of $1 at compound interest table can be used to find the present value factor for $1 to be received after a number of periods in the future.
Using the table, the present value of $1 to be received in two years with a 10% market rate is 0.82645. Multiplying the $1,000 by 0.82645 gives $826.45, the same that we got using the multiple divisions above.
Using the same example, if the interest was computed semiannually rather than annually, then there would be four periods over the two year life of the bond. In addition, because there are two periods per year, the percentage rate is divided by two. To find the correct percentage rate using the chart, you would use four periods of 5%, which equates to 0.80722. This would make the present value of the bond $807.22.
Present Value of the Periodic Bond Interest Payments: In addition to present valuing the face amount of bonds, the interest on bonds can also be present valued. This is the amount today that would need to be invested to yield the interest to cover the interest on the bond.
If the bond is $1,000 for two years, with 10% annual interest, the present value of the interest is $1,000 times 10% ($100) times 1.73554 (2 periods at 10% from the chart), or $173.55
The amount buyers are willing to pay for a bond is the sum of the present value of the face of the bond, and the present value of the interest. With a $1,000 10% annual interest 2 year bond, the present value of the face of the bond is ($1,000 times .82645) $826.45. The present value of the interest, as shown above, is $173.55. Therefore, the present value of the bond is $826.45 plus $173.55, or $1,000.
Bonds Issued at Face Amount
In this example, the market rate and contract rate are equal. Since they are equal, there is no discount nor premium. Therefore, when the bond is sold, the entry would be recorded as this:
| ||Bonds Payable|| ||$1,000|
Every year, interest payments are made on the bond of $100. The journal entry to record the interest would be:
|Interest Expense ||$100|
| ||Cash|| ||$100|
At the maturity date, the payment of the principal would be recorded as follows:
| ||Cash|| ||$1,000|
Bonds Issued at Discount
When the market rate is higher than the contract rate, the bond is issued at a discount. For example, if the market rate is 13%, and the contract rate is 12%, on a 5 year, $100,000 bond, compounded semiannually, then the present value would be calculated as follows:
The present value of the face is present value of $1 for 10 periods at 6.5% (0.53273) times $100,000 is $53,273.
The present value of the interest is present value of $1 for 10 periods at 6.5% (7.18883) times the annual percentage rate divided by two due to being semiannually (12% / 2, or 6%), times $100,000, is $43,133.
The present value of the bond is $53,273 plus $43,133, or $96,406.
The entry to record the issuing of the stock is:
|Discount on Bonds Payable||3,594.00|
| ||Bonds Payable|| ||$100,000.00|
The discount is viewed as the amount needed to entice investors to accept the contract at a rate of interest below the market rate. This is the market’s way of adjusting a bond’s contract rate of interest to the higher market rate. Because of this, GAAP requires that the bond discounts be amortized as interest expense over the life of the bond. In the above example, there are 10 payment periods. Using the straight line method of amortizing, each time interest is expensed, a tenth of the discount, or $359.40, must be recorded to amortize the discount. With the above example, the interest is 12% annually, but payments are made semiannually. This makes the interest 6% semiannually, or $6,000 ($100,000 times 6%). The entry to record the interest would be as follows:
| ||Discount on Bonds Payable|| ||$ 359.40|
| ||Cash|| ||6,000.00|
Bonds Issued at Premium
If the market rate was 11% and the contract rate 12% in the above example, then the bond would be sold at premium, because the rate is better than the market rate, so more people would want to buy that bond.
Using the charts, present value of the face is $100,000 times 0.58543 or $58,543. The present value of the interest is $6,000 times 7.53763 or $45,226. The present value of the bond then is $103,769. The entry to record the sell of the bond would be:
| ||Bonds Payable|| ||$100,000.00|
| ||Premium of Bonds Payable|| ||$ 3,769.00|
Amortization of bonds premium is basically the same for bonds discounts, except that the interest expense is decreased instead of increased.
|Premium on Bonds Payable||$ 376.90|
| ||Cash|| ||$6,000.00|
Zero Coupon Bonds
Some corporations issue bonds that provide only for the payment of the face amount with no interest at the date of maturity. Because they do not provide for interest, zero coupon bonds always sell for large discounts. The reason for this is that, using the example above for discount bonds, the present value of the $100,000 bond is the face value of $53,273, and an interest value of $0 (since there is no interest). Therefore the entry to record the sale of the bond would be:
|Discount on Bonds Payable||46,727.00|
| ||Bonds Payable|| ||$100,000.00|