BONDS Bonds are debt securities issued by companies to raise funds for capital expenditure, expansion, etc… Companies sometimes prefer to issue bonds because the interest is usually cheaper than the interest one would incur on a loan from a bank or other financial institution. One of the downfalls of bonds is that they can reduce your debt-to- equity ratio as well as any other ratio that factors liabilities in the denominator. The price of bonds is usually quoted as a percentage. If the percentage is greater than 100, the bond was sold at a premium. If the amount is less than 100, the bond was sold at a discount. If it was sold at 100, it is sold at par (face value). Let’s say you have a $500,000 face value bond. Here is what your entries would look like if it was sold at: 102 – This implies it was sold at a premium. The cash received is $500,000 * 1.02 = $510,000. The entry would be: Cash $510,000 Bonds Payable $500,000 Premium on Bonds Payable 10,000 (Notice that Premium on bonds payable is a CREDIT account. This is because it is an adjunct account and increases the underlying account, which, in this case, is the bonds payable). 97 – This implies the bond was sold at a discount. The cash received is $500,000 * 97% = $485,000. The entry would be: Cash $485,000 Discount on Bonds Payable 15,000 Bonds Payable 500,000 (Notice that the Discount On Bonds Payable is a DEBIT account. This is because it is a contra-liability account that is linked to Bonds Payable and reduces that account). *******We NEVER add/subtract the premium/discount directly to/from the Bonds payable account. We have to set up a separate Premium/Discount account for these amounts.******** 100 – This implies the bonds were sold at par. The cash received is $500,000. The entry would be: Cash $500,000 Bonds Payable 500,000
PRICING BONDS USING INTEREST RATES If the bond price is not quoted as a percentage, you have to price the bonds based on interest rates. There are usually two rates associated with a bond – the face (coupon) rate, which is the stated rate on the bond and is the rate that the bond pays to the bond holders. The other rate is the effective (market) rate, which is what the bond actually yields. From these rates, we can determine if the bonds sold at a premium or discount: If the Bond Coupon/Face Rate > Market Rate/Yield, the bond sold at a PREMIUM. This is because investors will get a better return with our security than with others in the market so we can charge more for it. If the Bond Coupon/Face Rate < Market Rate/Yield, the bonds sold at DISCOUNT. This is because we will have to sell our bond for less in order to entice investors. FR is face rate MR is market rate Face rate/Coupon rate/Stated/Nominal rate -all mean the same thing Market rate/ Effective Rate/ Yield - all mean the same thing So, looking at this from all angles: FR > MR = PREMIUM FR < MR = DISCOUNT MR > FR = DISCOUNT MR < FR = PREMIUM So, let’s say that you have a 5-year, $100,000, 10% bond that pays interest ANNUALLY.