Vital Knowledge

The Basics And Pricing Of Debt Securities (Bonds)

2012-06-15T01:31:00.014-04:00

When a company is fortunate enough to have excess cash sitting around it may invest in debt securities that are either issued by the government or other private entities. Similarly, a company in need of financing to improve its cash position may find it necessary to issue debt to investors who are interested in generating interest income in addition to any potential discount they can benefit from based on the face value of the bond.

Before going through any type of exercise, it benefits to become familiar with some important concepts and terminology as it relates to this topic. (Also take note that this is a shared topic that lends itself to finance and accounting) Specifically, you will want to understand the various elements of a bond in addition to concepts related to the time value of money.

Let’s begin by asking, what is a bond?

A bond is a debt instrument issued by organizations that promise the bearer a lump sum payment at maturity in addition to periodic interest payments until the bond becomes mature. A bond will have:

· Information about the issuer and a guarantee to pay at maturity

· A face value: the value printed on the bond representing what the bond can be redeemed for at maturity (i.e., $10,000)

· A stated interest rate: the annual rate at which cash will be paid periodically for the term of the bond. (i.e., 12% annually)

· The term or duration of the bond. (i.e., 10 years)

· Information about how often interest will be paid. (i.e., monthly, semi-annually, annually).

How are bonds issued?

Bonds can be issued in 3 distinct ways:

1. At par value: the bond is issued or sold for its face value

2. At a discount: the bond is issued or sold for less than its face value

3. At a premium: the bond is issued or sold at higher than face value

What determines the selling price of the bond?

The key variable that ultimately decides whether a bond will be issued at par value is the market interest rate, also known as the effective interest rate. The market rate is the prevailing rate for similar bonds with similar risks at the time the bond is issued.

When the market rate is:

· Equal to the stated interest rate of the bond, it will sell at face value.

· Greater than the stated interest rate of the bond, it will sell at a discount.

· Less than the stated interest rate of the bond, it will sell at a premium.

How does one go about determining the exact issue price of the bond if the stated interest rate and market interest rate are different?

Determining the issue price requires an understanding of the time value of money. Generally speaking it should make sense that $100 is worth more today than a $100 a year from now. The reason is that the $100 today can be invested for a return on principal. So it helps to look at future income in terms of what it is worth today. When one looks at money from this perspective they are essentially evaluating the investment in terms of what is known as present value (PV).

Determining present value is a very objective exercise and is backed by standard schedules / charts (Time value of money tables) that have defined values one should use in their calculations. How those values were determined are beyond the scope of this discussion and so it is not something to be concerned with at this point.

For the purpose of calculating the issue price of the bond, it is essential to understand that a bond has two different monetary elements. One is the lump-sum amount the bearer will redeem (the face value of the bond) and the other is the annuity (or periodic) cash payments made to the bearer for the term duration.

In order to determine:

· The lump-sum present value, the time value table that factors the present value of a $1 based on the market / effective interest rate needs to be used. Here is a link to the table: Present Value of a $1

· The total annuity payments present value based on the market / effective interest rate, use the time value table that factors the Present Value of an Annuity of $1

A few things to keep in mind about the time value tables.

The time value tables are based on number of payment periods and not the term or duration of the bond. So for instance, if you have a bond that matures in 10 years (the term) and interest will be paid semi annually (once every six months), then the total number of payment periods is 20 (10 years * 2 times a year).

Also, the stated or market interest rate discussed thus far are percentage rates that apply on an annual basis. So, if interest is paid on the bond once every six months as in the previous paragraph, then the annual interest rate will have to be divided by 2 in order to find the right present value factor in the time value tables.

EXAMPLES:

Exercise 1:

A company issued a 10 year, 12% (stated rate) bonds with a face value of $100,000 on January 1, 2009. Interest is payable semi-annually on June 30^th and December 31^st each year for the duration (term) of the bond until maturity. The market rate for similar bonds with comparable risks was 12% at the time of issuance. (1)Determine the issue price of the bond by calculating the present values of both the lump-sum payment and the interest payments for the bond’s term. (2) What type of bond is this?

Solution: Part (1)

1. Determine the interest payment periods = 10 years * 2 times per year = 20 total payment periods

2. Determine effective interest rate for each period = 12% annually / 2 periods per year = 6% per period

3. Determine the interest (cash) to be paid per period = ($100,000 (face value) * 12% (stated rate)) / 2 periods per year = $6,000 per period.

Now we can calculate the present values of the lump sum and the annuity.

Present value of the face value (lump sum) in 20 periods

= $100,000 * .3118 <---PV factor based on 20 periods at an effective interest rate of 6% for a lump sum

= $31,180

Present value of the cash interest payments (annuity) over 20 periods

= $6,000 * 11.4699 <---PV factor based on 20 periods at an effective interest rate of 6% for an annuity

= $68,820

Now we can calculate the issue price of the bond by adding the present value of the lump sum and the present value of the annuity.

$31, 180 + $68, 820 = $100,000

Solution: Part (2)

This is a par value bond since the bond issue price is equal to the face value of the bond. As discussed earlier, when the annual market rate / effective interest is equal to the annual stated interest rate of the bond, it will sell at par value.

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Exercise 2:

A company issued a 10 year, 12% (stated rate) bonds with a face value of $100,000 on January 1, 2009. Interest is payable semi-annually on June 30^th and December 31^st each year for the duration (term) of the bond until maturity. The market rate for similar bonds with comparable risks was 8% at the time of issuance. (1)Determine the issue price of the bond by calculating the present values of both the lump-sum payment and the interest payments for the bond’s term. (2) What type of bond is this?

Solution: Part (1)

1. Determine the interest payment periods = 10 years * 2 times per year = 20 total payment periods

2. Determine effective interest rate for each period = 8% annually / 2 periods per year = 4% per period

3. Determine the interest (cash) to be paid per period = ($100,000 (face value) * 12% (stated rate)) / 2 periods per year = $6,000 per period.

Now we can calculate the present values of the lump sum and the annuity.

Present value of the face value (lump sum) in 20 periods

= $100,000 * .4564 <---PV factor based on 20 periods at an effective interest rate of 4% for a lump sum

= $45, 640

Present value of the cash interest payments (annuity) over 20 periods

= $6,000 * 13.59033 <---PV factor based on 20 periods at an effective interest rate of 4% for an annuity

= $81,542

Now we can calculate the issue price of the bond by adding the present value of the lump sum and the present value of the annuity.

$45, 640 + $81, 542 = $127, 182

Solution: Part (2)

This bond will sell at a premium since the issue price is $27,182 ($127,182 - $100,000) more than the face value of the bond. As discussed earlier, when the annual market rate / effective interest is lower than the annual stated interest rate of the bond, it will sell at a premium.

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Exercise 3:

A company issued a 10 year, 12% (stated rate) bonds with a face value of $100,000 on January 1, 2009. Interest is payable semi-annually on June 30^th and December 31^st each year for the duration (term) of the bond until maturity. The market rate for similar bonds with comparable risks was 14% at the time of issuance. (1)Determine the issue price of the bond by calculating the present values of both the lump-sum payment and the interest payments for the bond’s term. (2) What type of bond is this?

Solution: Part (1)

1. Determine the interest payment periods = 10 years * 2 times per year = 20 total payment periods

2. Determine effective interest rate for each period = 14% annually / 2 periods per year = 7% per period

3. Determine the interest (cash) to be paid per period = ($100,000 (face value) * 12% (stated rate)) / 2 periods per year = $6,000 per period.

Now we can calculate the present values of the lump sum and the annuity.

Present value of the face value (lump sum) in 20 periods

= $100,000 * .2584 <---PV factor based on 20 periods at an effective interest rate of 7% for a lump sum

= $25, 840

Present value of the cash interest payments (annuity) over 20 periods

= $6,000 * 10.5940 <---PV factor based on 20 periods at an effective interest rate of 7% for an annuity

= $63, 564

Now we can calculate the issue price of the bond by adding the present value of the lump sum and the present value of the annuity.

$25, 840 + $63, 564 = $89, 404

Solution: Part (2)

This bond will sell at a discount since the issue price is $10,596 ($100,000 - $89,404) less than the face value of the bond. As discussed earlier, when the annual market rate / effective interest is greater than the annual stated interest rate of the bond, it will sell at a discount.

If you are interested in reading about how bond expenses are amortized over their term along with the accounting specifics, please read the article titled "Accounting for Bonds"

Basics of Inventory Valuation

2012-06-15T01:30:00.002-04:00

For merchandisers, manufacturers and wholesalers, inventory is often times the largest asset item represented on the balance sheet as a current asset. It is considered one of the more liquid assets because the basic assumption is that inventory owned by a company will be sold in the near future and converted to cash (the most liquid of any asset type). Inventory includes items that are ready for sale (finished goods), items in the process of being produced (work in progress) and raw materials that will be used to produce the final goods.

The way inventory is valued therefore becomes a crucial evaluation point for external parties comparing financial statements of similar companies. In addition to impacting the balance sheet, inventory management and the valuation method chosen by a company can directly affect profitability measures like gross margin on the income statement. Moreover, there is an impact to cash flow since profitability has a direct relationship with a company’s taxable income.

Inventory can be valued in multiple ways but there are three popular methods used by most companies that have layers of inventory to deal with.

1. First In, First Out (FIFO) – assumes that inventory produced first will be the first to be sold. For example, lets assume that a company produces widget-x and the cost to make these widgets changes depending on raw material costs. The company produces 50 units of widget-x for a cost of $5 a piece this week and another 50 units of widget-x for a cost of $7 next week. Lets also assume that two weeks from now the company sells 70 units to a retailer. Under FIFO, the cost of goods sold that will be reported on the income statement will consists of the 50 units from the first week at $5 a piece + 20 units from the second week at $7 a piece for a total of $250 + 140 = $390. If one were to prepare a balance sheet at the end of the third week, inventory will be valued based on the remaining 30 units from the second week at $7 a unit for a total of $210.

2. Last In, First Out (LIFO) – assumes that the most recently produced inventory will be the first to be sold. Using the same information from the FIFO example, lets see how LIFO changes things. On the third week when the sale is made, cost of goods sold reported on the income statement will consist of the most recent 50 units from layer 2 priced at $7 a unit + 20 units from layer 1 priced at $5 a unit for a total of $350 + $100 = $450. Assuming that the balance sheet is prepared at the end of the third week, inventory will be valued based on the remaining 30 units from the first week at $5 a unit for a total of $150.

3. Average Cost – takes the average of the various layers of inventory and uses one amount for all reporting purposes. Using the same example as the previous two methods, lets see how Average Cost changes things. At the end of the second week layer one’s value is 50 units x $5 per unit = $250. Layer two’s value is 50 units x $7 per unit = $350. So overall there are 100 units in inventory worth a combined total of $600. When 70 units are sold during week 3, the average cost of the 100 units available ($600/100 = $6 per unit) for sale is used to report the cost of goods sold. At $6 a piece the sale of 70 units will result in COGS of $420 and the remaining 30 units reported on the balance sheet will be valued at 30 x $6 = $180.

For the most part, choice of the method used depends on the nature of business, general economic conditions and business trends. For example, it wouldn’t make sense for a producer of perishable items like milk or cheese to use the LIFO method because that would not be a fair representation of the true flow of inventory. Certainly as an operator of such a business you’d hope to have the older of what is produced sold first.

But for those that are able to use LIFO, they can benefit from a reduction in tax liability because cost of goods sold is usually higher (where inflation exists) and taxable income therefore is lower. However, the representation on the balance sheet can be somewhat misleading especially if the older product‘s acquisition or manufacturing cost was significantly lower or if the inventory is potentially seen as obsolete.

Accounting for Bonds

2012-06-15T01:30:00.001-04:00

This is a continuation of “The Basics and Pricing of Debt Securities” post. If you have not read that post / are unfamiliar with how bonds are priced, please do so before reading this article.

Once the bond’s issue price has been determined, the issuing organization needs to account for all of the related transactions including the initial issuance of the bond and then the subsequent interest expense on a periodic basis. So let’s begin by preparing the initial journal entries to record the cash sale and the subsequent interest expense / payments for the three types of bonds discussed in “The Basics and Pricing of Debt Securities” post.

THE PAR VALUE BOND

Our par value bond will be issued in line with the face value of the bond and so the journal entry to record the sale is very simple. All that needs to be recorded is a debit entry to cash for the face value of the bond and a credit to notes payable for the same amount. Our face value of the bond as discussed in “The Basics and Pricing of Debt Securities” was $100,000 and this is what the journal entry will look like.

Date	Description		Debit	Credit
1-Jan-09	Cash		$100,000
		Notes Payable		$100,000
Notes: (To record the issuance of a par value bond)

Similarly, accounting for the payment of interest and the recognition of interest expense on a periodic basis are also very simple. When cash is paid at the end of a period, it is credited for that particular amount with a matching debit entry to recognize the interest expense. Our interest to be paid based on the par value example in “The Basics and Pricing of Debt Securities” post was $6,000 and this is what the journal entry will look like every June 30^th and December 31^st.

Date	Description		Debit	Credit
30-Jun-09	Interest Expense		$6,000
		Cash		$6,000
Notes: (To record the cash payment and interest exp for a par value bond)

Date	Description		Debit	Credit
31-Dec-09	Interest Expense		$6,000
		Cash		$6,000
Notes: (To record the cash payment and interest exp for a par value bond)

Lastly as far as the par value bond is concerned a journal entry at maturity is necessary to recognize the bond redemption from the investor. At the time a cash payment for the face value of the bond will be made by the issuer (credit to cash) and the accounting records are balanced by a debit to Notes Payable for the same face value. The journal entry will look like the following at the 10 year mark when the bond matures.

Date	Description		Debit	Credit
01-Jan-19	Notes Payable		$100,000
		Cash		$100,000
Notes: (To record the cash payment when the par value bond is redeemed)

BOND ISSUED AT A PREMIUM

Based on the annual stated interest rate of 12% and the market / effective annual interest of 8%, the $100,000 face value bond issued for a 10 year term was priced at $127,182 in exercise 2 of the “The Basics and Pricing of Debt Securities” article. Since the bond will sell at a value greater than the face value, this is a premium bond. Accounting for the initial bond issue for cash is slightly different than what was done for the par value bond. Although cash will be debited for the full $127,182 (the carrying value), the credit amount to Notes Payable will only be $100,000 since that’s what will be redeemed when the bond matures. This will result in a deficit on the credit side of the entry. The balance has to be accounted for with an entry to an account called “Premium on Notes Payable”. The journal entry on January 1, 2009 looks like the following.

Date	Description		Debit	Credit
01-Jan-09	Cash		$127,182
		Notes Payable		$100,000
		Premium on Notes Payable		$27,182
Notes: (To record the issuance of a premium bond)

The premium on notes payable ($27,182) reduced the cost of borrowing for the bond issuer and will be amortized over the term of the bond through a reduction in interest expense. Note: cash paid will be based on the stated interest rate and the face value of the bond. Interest expense recognition on the other hand will be lower each period because it will be based on the carrying value (in this case face value + the unamortized premium amount) and the effective interest rate that was determined as part of the solution to exercise 2 in “The Basics and Pricing of Debt Securities” article.

Before preparing the entries, it is useful to set up an amortization table that reflects how the expense recognition amount, amortization amount and the carrying value change over the term of the bond. Take note of the fact that straight line method for amortization of the premium is not GAAP compliant. Using the effective interest rate and the carrying value is the norm and is acceptable.

Amortization Table for the premium bond issued January 1, 2009.

Int. Pay Date	Cash (Interest) Payment	Interest Expense	Amortization Amount	Bond's Carrying Value	Unamortized Balance
Payment semi-annually (twice) over a ten year term	(Based on Face Value of $100,000 and stated interest rate of 6% per period)	Carrying Value * Effective interest rate for period (4%)	Cash Payment - Interest Expense	Reduced by amortization amount for the period	Reduced by amortization amount for the period


Date of Issuance	-	-	-	$127,182	$27,182

30-Jun-09	$6,000	$5,087	$913	$126,269	$26,269
31-Dec-09	$6,000	$5,051	$949	$125,320	$25,320
30-Jun-10	$6,000	$5,013	$987	$124,333	$24,333
31-Dec-10	$6,000	$4,973	$1,027	$123,306	$23,306
30-Jun-11	$6,000	$4,932	$1,068	$122,238	$22,238
31-Dec-11	$6,000	$4,890	$1,110	$121,128	$21,128
30-Jun-12	$6,000	$4,845	$1,155	$119,973	$19,973
31-Dec-12	$6,000	$4,799	$1,201	$118,772	$18,772
30-Jun-13	$6,000	$4,751	$1,249	$117,523	$17,523
31-Dec-13	$6,000	$4,701	$1,299	$116,224	$16,224
30-Jun-14	$6,000	$4,649	$1,351	$114,873	$14,873
31-Dec-14	$6,000	$4,595	$1,405	$113,468	$13,468
30-Jun-15	$6,000	$4,539	$1,461	$112,006	$12,006
31-Dec-15	$6,000	$4,480	$1,520	$110,487	$10,487
30-Jun-16	$6,000	$4,419	$1,581	$108,906	$8,906
31-Dec-16	$6,000	$4,356	$1,644	$107,261	$7,261
30-Jun-17	$6,000	$4,290	$1,710	$105,551	$5,551
31-Dec-17	$6,000	$4,222	$1,778	$103,773	$3,773
30-Jun-18	$6,000	$4,151	$1,849	$101,924	$1,924
31-Dec-18	$6,000	$4,077	$1,923	$100,000	$0

Based on this schedule it is easy to set up the relevant journal entries periodically. So far instance, on June 30, 2009 and on December 31, 2009, the journal entries to record the cash payment and interest expense will look like the following.

Date	Description		Debit	Credit
30-Jun-09	Interest Expense		$5,087
	Premium on Notes Payable		$913
		Cash		$6,000
Notes: (To record interest expense and cash payment for premium bond)

Date	Description		Debit	Credit
31-Dec-09	Interest Expense		$5,051
	Premium on Notes Payable		$949
		Cash		$6,000
Notes: (To record interest expense and cash payment for premium bond)

And finally as far as the premium bond is concerned a final entry at maturity is needed to reflect the redemption by investor(s). Since the carrying value on December 31, 2018 is the same as the face value, a debit to Notes Payable and a credit to Cash for $100,000 will balance the books.

Date	Description		Debit	Credit
01-Jan-19	Notes Payable		$100,000
		Cash		$100,000
Notes: (To record the cash payment when the premium bond is redeemed)

BOND ISSUED AT A DISCOUNT

Based on the annual stated interest rate of 12% and the market / effective annual interest of 14%, the $100,000 face value bond issued for a 10 year term was priced at $89,404 in exercise 3 of the “The Basics and Pricing of Debt Securities” article. Since the bond will sell at a value less than the face value, this is a discounted bond. Accounting for the initial bond issue for cash is slightly different than what was done for the par value bond and the premium bond. Although cash will be debited for $89,404 (the carrying value), the credit amount to Notes Payable will only be $100,000 since that’s what will be redeemed when the bond matures. This will result in a deficit on the debit side of the entry. The balance has to be accounted for with an entry to an account called “Discount on Notes Payable”. The journal entry on January 1, 2009 looks like the following.

Date	Description		Debit	Credit
01-Jan-09	Cash		$89,404
	Discount on Notes Payable		$10,596
		Notes Payable		$100,000
Notes: (To record the issuance of a bond sold at a discount)

The discount on notes payable ($10,596) added to the cost of borrowing for the bond issuer and will have to be amortized over the term of the bond through an increase in interest expense. Note: cash paid will be based on the stated interest rate and the face value of the bond. Interest expense recognition on the other hand will be higher each period because it will be based on the carrying value (in this case face value + the unamortized discount amount) and the effective interest rate that was determined as part of the solution to exercise 3 in “The Basics and Pricing of Debt Securities” article.

Once again, before preparing the entries, it is useful to set up an amortization table that reflects how the expense recognition amount, amortization amount and the carrying value change over the term of the bond. Take note of the fact that straight line method for amortization of the discount is not GAAP compliant as it was with the premium example. Using the effective interest rate and the carrying value is the norm and is acceptable.

Amortization Table for the discounted bond issued January 1, 2009.

Int. Pay Date	Cash (Interest) Payment	Interest Expense	Amortization Amount	Bond's Carrying Value	Unamortized Balance
Payment semi-annually (twice) over a ten year term	(Based on Face Value of $100,000 and stated interest rate of 6% per period)	Carrying Value * Effective interest rate for period (7%)	Interest expense - Cash payment	Increased by the amortization amount for the period	Reduced by amortization amount for the period


Date of Issuance	-	-	-	$89,404	$10,596

30-Jun-09	$6,000	$6,258	$258	$89,662	$10,338
31-Dec-09	$6,000	$6,276	$276	$89,939	$10,061
30-Jun-10	$6,000	$6,296	$296	$90,234	$9,766
31-Dec-10	$6,000	$6,316	$316	$90,551	$9,449
30-Jun-11	$6,000	$6,339	$339	$90,889	$9,111
31-Dec-11	$6,000	$6,362	$362	$91,252	$8,748
30-Jun-12	$6,000	$6,388	$388	$91,639	$8,361
31-Dec-12	$6,000	$6,415	$415	$92,054	$7,946
30-Jun-13	$6,000	$6,444	$444	$92,498	$7,502
31-Dec-13	$6,000	$6,475	$475	$92,973	$7,027
30-Jun-14	$6,000	$6,508	$508	$93,481	$6,519
31-Dec-14	$6,000	$6,544	$544	$94,024	$5,976
30-Jun-15	$6,000	$6,582	$582	$94,606	$5,394
31-Dec-15	$6,000	$6,622	$622	$95,228	$4,772
30-Jun-16	$6,000	$6,667	$667	$95,895	$4,105
31-Dec-16	$6,000	$6,714	$714	$96,609	$3,391
30-Jun-17	$6,000	$6,764	$764	$97,372	$2,628
31-Dec-17	$6,000	$6,817	$817	$98,190	$1,810
30-Jun-18	$6,000	$6,874	$874	$99,064	$936
31-Dec-18	$6,000	$6,936	$936	$100,000	$0

Date	Description		Debit	Credit
30-Jun-09	Interest Expense		$6,258
	Cash			$6,000
		Discount on Notes Payable		$258
Notes: (To record interest expense and cash payment for a discounted bond)

Date	Description		Debit	Credit
31-Dec-09	Interest Expense		$6,276
	Cash			$6,000
		Discount on Notes Payable		$276
Notes: (To record interest expense and cash payment for a discounted bond)

And finally as far as the discounted bond is concerned a final entry at maturity is needed to reflect the redemption by investor(s). Since the carrying value on December 31, 2018 is the same as the face value, a debit to Notes Payable and a credit to Cash for $100,000 will balance the books.

Date	Description		Debit	Credit
01-Jan-19	Notes Payable		$100,000
		Cash		$100,000
Notes: (To record the cash payment when the discounted bond is redeemed)