There are costs associated with issuing a bond. These bonds are called Issuance
Costs. In the past, the accounting treatment of issuance costs was
different between IFRS and US GAAP, but now that has changed. Under both IFRS and
US GAAP, companies initially report bonds as a liability on the balance sheet at
the amount of the sales proceeds net of issuance costs. So the point now is that
both standards have converged with respect to the treatment of issuance
costs.
Okay now some general points, the effective interest rate does not change
during the life of the bond. The point here is let's say that you are the
investor and I'm the company so I issue a bond, when I issued the bond the
interest rate was 10% so essentially I issued a par value bond. Now after that
the rate in the market will keep changing but as far as I am concerned,
the company is concerned, I am going to record as if the rate is 10% so I use
the effective interest rate which is what the market rate was when they
issued the bond that doesn't change. Another point is that the book value of
a bond rises for a discount bond and falls for a premium bond and hopefully
you saw this. If we look at a time line and let's say that this value here
represents par. If I issue a discount bond, will I issue it at a price of
100, more than 100, less than 100. It would be less than 100, let's just
say for simplicity that I issue the bond at 96, this is a discount bond and this
is a 3 year bond so what will happen over a 3-year period? The value of
the bond on my books--I, being the company, will rise to 100. Why? Because I am amortizing
and at the end of 3 years what's my liability? It is 100, so on my books I
will slowly increase the value so that ultimately the payable is 100. What about
a premium bond. So if a bond had been issued at 104 then what happens to the
book value over the 3 years? Then it would decrease. Okay now, here is another
point that some people get confused about.
We just talked about amortizing the discount, okay so we used the term
amortize. In the previous reading on long-lived assets, there we also use the
term depreciation and amortization, so when we used amortize in the previous
reading on long-lived assets and when we use the term amortize over here, is it
the same thing or is it different? There is actually a similarity. What is the
similarity? A lot of people don't think about it, but I will help you through
this. What do you do when you amortize or you depreciate. You have an asset, for
example, let's take a very simple example. Initial value of the asset is say 100
and you expect that after 9 years, the value of the asset will be down to 10,
so if this is a tangible asset, you say depreciation. If it is intangible
asset you say amortize. Let us just say that this is an intangible asset.
What does amortization mean? It means that you are going through a process to
reduce the book value down to 10, which is what you expect the book value to be
ultimately. Now notice that this was done for...an asset. What are we doing
through amortization with a bond? In a sense we are doing the same thing. If a
bond was initially at 104 and after three years the expected value is 100,
through amortization we are just adjusting the book value of that bond
liability, so that ultimately it is down to 100, which is what you expect the
liability to be after three years. So in a sense, amortization has the same
meaning. In both cases, on the asset side and the liability side we are just
making changes to the value on the books so that ultimately the value on the
books represents what you expect the final liability to be. All right, and then
finally the effective interest rate method versus straight line method. I do
think this is overly testable but everything that we've talked about so
far is based on the effective interest rate method so we have said that the
effective interest rate is the rate that was in effect when the bond was issued,
and then all our subsequent amortization and interest expense is calculated based
on that effective interest rate. Now, another method for amortization would be
a straight line method which is allowed under US GAAP where you say that okay,
the bond is initially at 104, I will bring the value down to 100 using a
straight line method just like we do with straight line depreciation. So
recognize that this method exists and recognize that it would simply be an
equal amortization over the period. With the effective interest rate method, the
amortization is not equal and you can see that from the examples that we have
discussed, but if you are not told what method to use the default, in general, is
to use the effective interest rate method. I want you to do this question
now. So the numbers you look at here, the coupon rate is 8.5% which is more than
the effective interest rate and that is the rate which was in effect when the
bond was issued. When this happens then you have a premium bond. This is a very
simple question and it's a sort of question that you might expect on the
exam. This other number, the market rate of interest today is 9% that is
irrelevant in the context of this question. Okay try this one now. So here
is how you look at this problem. We have recognized that we have a premium bond
so it will be issued at a price above par. I have just picked some numbers here,
it doesn't really matter but it helps you solve a problem when you are working
with simple numbers. Say 100 is the par value, let's say
that when the bond was issued it was issued at a premium, say at 104. At the
end of 5 years, the bond will be back down to par, that means that two years
into the life of the bond or any time actually between issuance and maturity
the book value will be above par. Our discussion so far has focused on
reporting bonds at amortized cost, this method reflects the market rate at the
time the bonds were issued. So let's take a bond where a time of issue the market
rate is less than the coupon rate, this would mean that the bond is issued at a
premium relative to par and over time the book value of the bond will come
down to par value. So this value over here is going to represent the amortized
value or the amortized cost of the bond. If interest rates in the market change
then obviously the fair value will be different from the reported book value.
Under the method that we've talked about so far, that fair value has no impact on
what is shown on the financial statements of a company, however under US
GAAP and IFRS, companies now have the option to report financial liabilities
at fair value. This means that if the fair value changes then the book value
can also change and that would imply that we need to report either again or a
loss. Now if interest rates change such that the fair value comes down then this
means we have a reduction in liability and the reduction in liability
represents a gain. On the other hand, if the fair value goes up that means that
we have an increase in liability and an increase in liability would represent a
loss. We should recognize that there are two major reasons for why a bond's fair
value might diverge from reported value. One has to do with simple
changes in market rates, and the other is that the credit risk of the company that
is issuing the bond changes. The way we deal with gains or losses that result
from these two areas is different. If a bond value changes because of changes in
market rates then the gain or loss is reported in the profit and loss
statement or the income statement, however if the change in value is
because of a change in credit risk and this is the credit risk of the company
that has issued the bond then this gain or loss is reported in other
comprehensive income. It does not flow through the income statement.
Derecognition of Debt. What does this mean? It's a fancy term, but effectively it
means that a company has issued a bond. Now when company issues a bond either
the bond can remain issued and then at maturity the company pays off the par
value, so that's one scenario, or effectively the company can pay off the
investor and retire the debt so that's called redeeming the bond, and later on
you will look at different ways of redeeming a bond, but essentially the
company is paying off the investor before the bond matures. Once bonds are
issued a company may leave the bond outstanding until maturity or redeem the
bond before maturity. When a company redeems the bond before maturity, there
is a good chance that the amount of money that the company is paying to
redeem the bond is different from the book value of the bond. How is that
accounted for? There will be again or a loss. Obviously, if the company is paying
more than the book value then that should be a loss. If the company is
paying less than the book value then that would be a gain. Where will that gain
or loss be shown? It will be shown on the income statement, but first let's make
sure we understand how to do the basic calculation.
The gain is equal to the redemption price minus the book value of the
liability at reacquisition date so let's say that the redemption price is
1,020,000. The book value is this. Is this a gain or a loss? It is a loss
because the amount that is being paid is more than the book value so more cash is
going out so in this particular case the loss is 30,000. The gain or loss
from extinguishing debt is reported in the income statement in a separate line
item where the amount is material, so if the amount is almost insignificant then
you don't need to show it as a separate line item. Dealing with bond issuance
costs. Do you remember we talked earlier about the fact that when a bond is
issued there are going to be certain costs, issuance costs, what did US GAAP
say? US GAAP said that when you issue a bond, the issuance cost has to be
capitalized and then amortized over the life of the bond. So if a bond has a
five-year life and then after 3 years it has been redeemed. Will there be
some issuance cost on the balance sheet? It will be. So the unamortized bond
issuance cross must be written off and then included as a gain or loss in the
calculation. Obviously it would be a loss if you are writing off the asset. What
about IFRS? There is no write off because the issuance cost is included in the
book value of the bond liability. We are coming to the end of the segment on
bonds. Debt Covenants. Again we will talk about these briefly here and then in
more detail in fixed income. Debt covenants are restrictions on the issuer
that protects the bondholder's interest. So if I am a company I've issued
a bond. Obviously, I have borrowed money from you, so they need to be some
restrictions on me or some rules that are that I need to follow in order to
make you comfortable, the investor comfortable. These restrictions reduce
default risk, the risk of me--the company defaulting, and if the risk of me
defaulting is less then that also reduces my interest cost because if my
risk of default is low then I can borrow money at a lower interest rate. When we
talk about debt covenants, very broadly speaking, we can either have affirmative
covenants or negative covenants. And simplistically, affirmative covenants are
covenants where I, the company or the issuer, say that I will do so-and-so, so I
will pay my coupon payments on time, I will make my payments I will
pay my taxes and so on. So all the places where the covenants is that the company
will do so and so, they are called affirmative the covenants. Where a
company is saying that it will not do so and so, for example, a company will not
issue new debt, those are examples of negative covenants. Now both positive and
negative covenants are there for the benefit of the investor. Technical
default. This is the term used where one of the covenants have been violated, so
for example, a company says that it will not issue new debt but it issues new
debt even though the payments to the investor are being made but one of the
covenants has been violated that is called a technical default. Presentation
and Disclosure of Long-Term Debt. You can read this, but I will give you the basic
points and most of this you know already. When you have long-term debt the current
portion of the long-term debt which is due within one year is shown under
current liabilities, the rest is typically shown as a single line item on
on the non-current liabilities and then if you look at the footnotes, and
disclosures there'll be this amount of information about all the
long-term debt and then you can also find additional information in the
management discussion and analysis about company's capital resources which
includes debt financing and off-balance sheet financing. Off-balance sheet
financing is where a company raises money but doesn't show it on the balance
sheet and that happens through leases, and specifically operating leases. That
is what we will discuss next.