I'm Larry Walther.
This is principlesofaccounting.com, Chapter 9.
In this module, we will be looking at accounting for
the investment category, Held to Maturity.
So held to maturity of those investments that were purchased with
the intent to maintain them for the life of the investment to a fixed maturity date
typically accounted for by the amortized cost method.
Bonds are an example of a typical held to maturity security.
A bond enables a large corporation to borrow amounts from lenders where
maybe a single lender is not large enough or has the capacity to make the loan.
Instead, the company issues bonds enabling many different individual investors to
buy bonds or in essence, loan money to the company through small units.
For example, a bond issuer may borrower $500 million by issuing 500,000
individual $1,000 face amount bonds to raise the full 500 million dollar amount.
There's some terms that are important to know when you consider bonds.
The face amount, that's the amount that's to be repaid at maturity, typically,
a $1,000 amount.
The contract or
stated rate of interest is the payment that is contractually agreed to.
For example, 5% per year, or perhaps paid semi-annually 2.5% semi-annually, for
example.
Term is the time to mature, for example, 5 years, 10 years, 20 years, 30 years,
whatever that might be.
Here's an example, a $1,000, 5%, 10-year bond would pay $50 per
year of interest for 10 years, and then it would repay the $1,000 at maturity.
So an investor would initially give money to the company.
The company would issue the bonds to the investor and
those bonds would require periodic interest payments.
And then at the maturity, the bond, the full face amount back to the investor.
It's just a loan in other words.
How much would one pay for a bond?
What would be the issue price?
Well, it really depends on many factors including the credit worthiness of
the issuer, remaining time to maturity, and the overall market conditions for
bonds at the time they're issued.
We can think about a going rate or market rate of interest for bonds.
Let's assume that going rate or
market rate was 8% at the time that a company had attempted to issue a 5% bond.
Well who would want the 5% and
the answer is really no one unless they could buy it at a discount?
Conversely if the going rate of interest the market rate was 3%
everyone would clamor to buy 5% bonds.
They would actually bid the price of the bonds up such that the investment
would be at a premium.
If the market rate of interest and stated rate of interest are similar we
would expect the bond or issue or sell or price at par.
If the interest rate on a particular bond, the contract rate is above the market rate
of interest, we would expect a premium and conversely for a discount.
Price is stated as a percentage of face.
103 means 103% of face value, or $1,000 bond the price would be $1,030.
An investment bond account is established at the time of purchase.
It includes the purchase price of the bonds plus the transaction costs.
Any premiums or discounts on those bonds are included
in the carrying value of the investment bonds account.
Here's an example of s bond issued at par.
The investor buys the bond, debit investment bonds 5,000 credit cash, 5,000.
As interest payments were received we debit cash and credit interest.
We bought $5,000 of bonds yielding interest at 5% per year.
So that's $250 per year and we're dealing with 6 months here or
half a year so we expect to collect $125 of interest income.
That entry would be made at each interest payment date and of course any accrued
interest at the end of the accounting cycle would also need to be recorded.
At maturity we get our $5,000 back debit cash credit investment in bonds.
Now for example assume the same facts is on the preceding 5% bond but
this time the market rate of interest was less than 5% when the bond was issued.
Now the bond would be purchased at a premium.
Simply assume we invested a $5,000 face amount of bonds at $5,300.
We'll record the investment at $5,300 and credit cash $5,300.
Now, the investor paid an extra $300 because they recognized the value
associated with the superior rate of interest on these particular bonds.
But we're only gonna get 5,000 back at maturity.
That $300 you want to pay up front, we don't get back.
We get it back in the higher interest payments, but
we don't get it back in terms of maturity value.
The maturity value is only $5,000.
And so we have an accounting challenge here.
The investor pays more than the face value up front.
The bond's maturity value is unchanged.
The investor's likely generating annual interest received.
Now let's look at the calculations here.
We collect our $125, that's the 5% of the the $5,000 face for half a year.
The 125 received, 75 is recorded as interest income and
the other 50 is treated as return of the investment.
The $50 corresponds to the premium amortization,
$300 of premium and this was a 3 year life bond so
we will need to amortize that over 3 years, that comes to $50 every 6 months.
It is allocated evenly over the life
of the bond under this approach which is the straight-line method of amortization.
In a subsequent chapter we'll look at an effective interest method
amortization as well.
That premium amortization is credited against the investment bonds
account as shown in the journal entry, and
that process would continue with each interest payment date.
This entry reflects that we get the $5,000 back at maturity, debit, cash and
credit, investment and bonds.
That 5,000 is the right amount for the investment in bonds at that point,
because it started at 5,300 but we took $50 out of that account every 6 months for
3 years, or $300 in other words, so we're down to that amount.
Let's think about the cash effects.
We invested $5,300.
We got back $5,750, that is $125 every 6 months for
3 years and $5,000 at maturity.
That's a difference of $450 and, indeed,
that's the amount of income we recognized under this method.
Our journal entry showed $75 of interest income every 6 months for
3 years or a total of $450.
So indeed, the change in cash is what we recognized as interest income.
Here's a spreadsheet that's also repeated in the textbook.
It reveals the cash flow and activity for each payment.
We initially had $5,300 of cash going out, we had $125 coming in and
$5,000 at maturity.
So the net change in cash corresponds to the total interest income where we
recognize $75 at each interest payment date.
The difference is our premium amortization which is offset against
the investment account reflecting the decline in investment.
Discounted Bonds is just the opposite.
We'll essentially look at the same illustration in reverse here.
An investor pay less than the face value up front but
the bonds maturity value is unchanged.
So we're gonna get back more money then we invested in addition to the periodic
cash payment.
We bought this bond at a discount though cuz it was sort of an inferior bond,
it didn't pay very much on a periodic interest payment.
So let's assume we have the same facts as for the first bond but
this time this market rate of interest when we bought the 5% bond, the market
rate was more than that so we had to buy this at a discount or not be interested.
Up front we bought the bond for 4,850.
So we'll debit in investment bonds 4,850 and credit cash 4,850.
The investor gets the other 150 back at maturity when they get their 5,000 back.
And so that's 150,000 needs to be amortized over the 3 years,
at $25 every 6 months.
So if we look at the journal entry,
our cash flow is the same, 5,000 times 5% for half a year.
At each interest payment date, we'll debit cash 125.
Our investment and bond account is reduced by $25 however,
to reflect the amortization the $150 spread over 3 years.
And we're gonna book 150 as interest income.
In maturity we get our 5,000 back, debit cash and
credit investment and bonds 5,000.
Thinking about the cash, we paid out $4,850, we still got back the contracted
$5,750, a difference of $900 which should be recognized as interest income and
indeed, $150 every 6 months, for 3 years, comes to $900.
It's not difficult,
but it involves some complexity that takes you a while to get your arms around it.
And I know from years of teaching experience that this is one
subject where students struggle sometimes.
And so don't be frustrated by your struggle, but
do press through it to till you get your arms around this topic