I'm Larry Walther.
This is PrinciplesofAccounting.com, chapter 13.
And in this module, the discussion will relate to the pricing of bonds and
the basic accounting for bonds that are issued with par.
Another module would follow up with the accounting for
bonds that are issued with premiums and discounts.
Let's begin by thinking about what a bond is.
A bond is a promise to pay a stream of future cash flows as well as
the maturity value.
So, a $1000, 10% bond would pay over the course of a year,
$100 per year in interest.
And at the maturity of the bond, the $1000 would be repaid.
And so a bond payable is a blend really of annuity, the interest, the periodic
interest payments and the lump sum amount the amount that's due at maturity.
And the amount an investor would be willing to pay for
this bond to buy the bond issued by a company, would require consideration of
the present value of the cash flows in the bond agreement.
Investors will pay a price that makes the effective yield on the bond
equal to the market yield for those bonds at the time of issuance.
So let's think about bonds that are priced at par.
Now this means that they're stated rate is equivalent to the market rate
of interest at the time they're issued.
Investors would pay a price equal to the face value of the bond.
A bond at a premium, however, in this case,
the stated rate of interest is greater than the market rate of interest.
This should be fairly intuitive, someone to pay a premium for a bond,
a price in excess of its face value, there's something they really want or
like about that bond.
And what it is,
is that it bears a better rate of interest than the going rate of interest.
Now conversely bonds at a discount, these would be bonds that have an interest rate,
an offering or stated rate, that's well below the market rate of interest.
They're unattractive.
The only way you can entice investors to buy those bonds
is to sell them at a discount.
The specifics of how you would calculate premiums or discounts is really a function
of the present value considerations that we discussed in a previous module.
Let's assume for example, if we have a $1,000 face value,
5-year, 8% bond and it's paying interest every 6 months.
And so when we look at the facts here,
what we'll notice is that it will pay $40 of interest every 6 months.
That is 8% of $1,000 is $80 per year and
we're talking about semi annual periods or $40 every 6 months.
And then at maturity it will pay the $1000.
First of all, assuming that the market rate of interest is 8%,
which equates to the stated rate, I've shown how the present value of
the payments that is $40 times the present value factor for a 10 period 4% annuity.
That's the same as 5 years 8% but more frequent compounding.
10 periods, 10 semiannual periods at 4% per period.
The present value, the interest payments has a present value of 324.
And the present value of the maturity value,
the $1,000, has a present value of 675.
So that bond would be priced at $1,000.
The calculated value of the bond, $1,000, is equal to it's
face amount because its stated rate is equal to the market rate of interest.
If we look at a premium scenario,
now I'm going to assume the market rate of interest is 6%.
People would clamor to get the 8% bonds, they would pay a premium.
Now in this case they'll pay $1,085 for
the bond that consists of the present value of the stream of payments of $40.
The present value factor for ten periods at 3%, half of the 6% market
right per period, is 8.53 times the $40 is the present value of the interest is 341.
And the present value of the principal is 744.
So, again, we can check that off and
see that investors will pay $1,085 for that bond.
And lastly, we've got the bonds where the market rate and
interest is 10%, our 8% bonds are not looking so good.
I've recalculated the present value of the payments using a 5%,
10 period annuity, along with the present value the principal and
we come up with the $922.78 valuation for that bond.
So very simply, that's how market prices bonds when the market rate of interest
changes or it's different from the stated rate in a bond.
This is by way of note, you might see a bond price at 102,
that will be a 102% of par value.
Or $1,000 bond will be priced to that a $1,020.
But often times you'll see, for example, a price of 103.08,
bonds customarily price in 30 seconds, so that your 103.08, that's not a 103.08%.
It's 103 and 8th, 30 seconds which comes to a price of $1,032.50.
Let's look at the accounting for bonds issued at par.
Assume the company issued 100 of its 5 year 8% bonds at par.
Here would be the entries.
We begin by debiting cash and crediting bonds payable.
That's to record the amount received from the borrowing.
And again, we got par value for those bonds when they were issued.
Every six months, periodically we'll need to record the interest payment.
Credit, cash, and debit interest expense, $4,000.
That's the 8% for half a year of the $100,000 amount.
That continues for each of the ten periods.
Each of the ten semi-annual periods.
And then in maturity we'll repay the $100,000.
So that accounting is not too complex.
In the next module, we will look a little bit deeper.
We're going to look at the situations where there's a premium and
discount using the numbers from the illustration from the calculations we
looked at in this illustration.