LOS A requires us to:
determine the initial recognition, initial measurement, and subsequent measurement of bonds.
Bonds are the debt instruments, through which the investors lend money to the entities, in return for the promise to pay a certain fixed amount (including the principal and interest), on a pre-specified schedule. There are basically two types of payments for a bond, i.e. periodic interest payments and repayment of principal at maturity.
Before we discuss the types of bonds, here is a list of important bond terminologies that would help understand the mechanics of bonds:
a. Face Value. It is the par value or the maturity value of the bond that is repaid at the time of its maturity.
b. Coupon Rate. It is the interest rate that is used to calculate the periodic payments.
c. Coupon Payments. It is the periodic payments calculated at the coupon rate multiplied by the face value.
d. Effective Rate of Interest. It is the true rate at which the interest is earned. It is the economic rate of interest that equates the discounted value of all the future payments for the bond (including the coupons, premiums, and principal repayment) with the face value of the bond.
e. Balance Sheet Liability of the Bond. It is the discounted value of the remaining payments of the bond. On the balance sheet, the bond is valued at this amount.
f. Market Rate. It is the rate prevalent at the time of issuance of the bond. This rate is often the effective interest rate, as it equates the future payment against the bond with its issuance price.
g. Interest Expense. It is the expense that is reported in the income statement. It is calculated by multiplying the book value of the bond with the market rate.
The bonds could be issued at par, premium, or discount depending upon the market rate prevalent. These are discussed in details below:
1.1. Bonds Issued at Par
a. If the coupon payment on the bond equals the market rate of interest, it would be issued at par.
b. When the bonds are issued at par, they should usually be carried at the face value in the balance sheet, throughout the life of the bond, since there is no amortization of premium or discount during the bond’s life.
c. Since the market rate of interest equals the coupon payments equals the market rate of interest or the effective rate, therefore, the interest expense also equals the coupon payments. Also, due to the same reason, the interest expanse equals the actual cash flows.
1.2. Bonds Issued at a Premium
a. If the coupon payment on the bond is greater than the market rate of interest, it would be issued at a premium.
b. When the bonds are issued at a premium, their carrying value keeps getting reduced during the life of the bond. This is mainly because of the amortization of the bond premium over its lifetime. In the beginning, the bonds are carried at the face value plus the premium paid for the issue. But as the premium gets amortized over the life of the bond, the carrying value also keeps decreasing, till it reaches the face value at the time of its redemption.
c. When the bonds are issued at a premium since the coupon payments are higher than the market rate of interest, the interest expense (which is dependent upon the market rate) is less than the coupon payments. Also, the actual cash flows are higher than the interest expense. The interest expense is coupon payment less the amortization of premium.
Interest Expense = Coupon Payments – Amortization of Premium |
1.3. Bonds Issued at a Discount
a. If the coupon payment on the bonds is less than the market rate of interest, it would be issued at discount.
b. When the bonds are issued at a discount, their carrying value keeps increasing during the life of the bond. This is mainly because of the amortization of the bond discount over its lifetime. In the beginning, the bonds are carried at the face value less the discount on the issue of bond. But as the discount gets amortized over the life of the bond, the carrying value also keeps increasing, till it reaches face value at the time of its redemption.
c. When the bonds are issued at a discount, since the coupon payments are less than the market rate of interest, the interest expense (which is dependent upon the market rate) is higher than the coupon payments. Also, the actual cash flows are lesser than the interest expense. The interest expense is coupon payment plus the amortization of discount.
Interest Expense = Coupon Payments + Amortization of Discount |
2. Initial Recognition, Measurement, and Subsequent Measurement of Bond
2.1. Initial Recognition
a. Initially, the bonds are recognized at the proceeds of the bonds at the time of issuance.
b. So, if the bonds are issued at the par, they are initially recognized at their face value.
c. If they are issued at a premium or discount, they should be recognized at the premium or discounted value.
2.2. Subsequent Measurement
a. After the initial recognition, the bond is carried at the balance sheet at the present value of all cash flows from the bond (including coupon and principal repayment), at the market rate of interest.
b. Under IFRS, the liability for ‘bonds payable’ is reflected at the net proceeds from the sale, i.e. gross value is reduced by the issuing charges if any.
c. The charges so reduced are amortized upwards during the lifetime of the bond, till it reaches the par value at the time of redemption.
d. Under GAAP, however, the liability for ‘bonds payable’ reflects the gross proceeds from the sale.
e. The issuing charges, if any, would be reflected as a deferred asset on the balance sheet, and would be amortized over the life of the bond on a straight-line basis to the relevant expense.