0:02

>> Hello, I'm Professor Brian Bushee.

Â Welcome back.

Â In this video, we're going to continue our look at bonds.

Â Looking at issues like discount bonds, premium bonds,

Â retirement before maturity and how all of this affects the statement of cash flows.

Â Let's get started.

Â Okay. So

Â let's talk about what we mean by discount and premium bonds.

Â So in the example that we did last video, the KP bond.

Â KP bond was assumed to be issued at par.

Â Which means that its coupon rate, 5% equal the effective rate or

Â the market rate when the bond was issued, which was also 5%.

Â So issued at par, means coupon rate equals the market interest rate.

Â 0:56

So the price is going to be below face value.

Â Investors are willing to pay less for

Â the bond because the coupon rate is less than the current market rate.

Â So if the coupon rate was 5% but

Â the market rate is 6%, you're getting less interest from the bond.

Â So you're going to pay less than the face value to get the bond.

Â So if it's 10,000 bond, dollar bond, you'll pay less than 10,000.

Â When the coupon rate is above the market rate,

Â the bond is referred to as a premium bond.

Â So here the price is going to be above face value.

Â Investors are willing to pay more for

Â the bond because the coupon rate is greater than the current market rate.

Â So the coupon rate is 5%, the market rate is only 3%.

Â So you're getting much more payment with the bond.

Â So you're going to pay more than the $10,000 face value to get that 5%

Â coupon rate instead of the market rate of 3%.

Â 2:03

>> Wow, [LAUGH] we're off to a good start.

Â So, a discount bond does not mean that you're getting a deal.

Â It's not in the clearance aisle.

Â All a discount bond means is that the proceeds are below the face value.

Â But that's the case because the market interest rate is above the coupon rate.

Â And that lower proceeds simply reflects the correct price based on

Â the time value of money.

Â You're not getting a deal with a discount bond, you're playing exactly the right

Â amount based on the time value of money assuming current market rates.

Â 2:36

So now, let's talk about interest expense.

Â So in the prior video,

Â we saw that interest expense equaled the coupon payment.

Â But that's only going to be the case when the bonds are issued at par,

Â when the proceeds from the bond equal the face value.

Â So if you have a $10,000 face value bond, you receive $10,000 proceeds.

Â What it means is that the coupon rate was the same as the market rate.

Â And so interest expense equals cash, the coupon payment.

Â [NOISE] But

Â most of the time [LAUGH] when companies issue bonds, they're issued at a discount.

Â Sometimes at a premium.

Â And the interest expense has to be

Â based on something called the effective interest rate.

Â The effective interest rate is the market rate that was

Â in effect at the time you issued it.

Â So when you issue the bond, it was the interest rate that the investors were

Â willing to pay you based on their present value calculations.

Â 3:26

That effective interest rates what we're going to use for accounting and

Â it's not changed over the life of the bond.

Â So even if market interest rates go up or

Â down, we keep the same effective rate throughout the life of the bond.

Â [SOUND] So the format that we're going to use for

Â the interest expense journal entry is the following and this is an important one, so

Â you want to make sure you get what this one down.

Â Although [LAUGH] you're going to have plenty of practice as we go

Â through the rest of the video.

Â So we're going to debit interest expense,

Â we're going to recognize interest expense on the income statement.

Â The dollar amount is going to be equal to the balance and

Â bonds payable to beginning of the period times the effective interest rate.

Â So this interest rate that was in effect when the bond was issued.

Â 4:06

The credit to cash is going to be the coupon payment.

Â So the face value on the bond times the coupon rate.

Â And notice those are only going to be the same if the face value equals the balance

Â in bonds payable and if the coupon rate equals the effective interest rate.

Â And that's only going to be the case when the bond's issued at par.

Â For all of these discounter premium bonds, they are going to be different and

Â what we're going to need is a plug to bonds payable.

Â So we're either going to debit or

Â credit bonds payable if we issue a bond at a premium or

Â discount, which will mean that this interest expense does not equal cash.

Â So if interest expense does not equal cash, we're going to need a debit or

Â a credit to bonds payable to make this thing balance.

Â 4:51

>> Let me get this straight.

Â The cash interest payment made by the company is not the same as

Â interest expense.

Â We use the interest rate in effect when the bond was issued,

Â even if it was issued a long time ago and the interest rate has changed.

Â And we might have to debit or

Â credit the notes payable principal amount, even when we are not paying any principal.

Â This is most convoluted accounting I have ever seen!

Â >> It is almost as convoluted as the plot for Tomorrow Never Dies.

Â That was a bad bond video!

Â 5:37

So lets take a look at how this journal entry works with some examples.

Â So again, a bond issued at par would be the effective rate is the same as

Â the coupon rate.

Â So the coupon rate is what the bond is paying in cash every six months.

Â That rate is exactly the same as what the market views the interest rate for

Â the bond to be, so

Â we get proceeds the present value of 10,000 equals the face value.

Â So the interest expense is 250, that's the bonds payable

Â balance the 10,000 of proceeds times the effective interest rate, 5%.

Â But of coarse, it's divided by 2 since it's some annual to 2 and a half percent.

Â [SOUND] We credit cash for 250, that's the $10,000 face value times the coupon rate.

Â To get the coupon payment.

Â Coupon rate is 5%.

Â But again, we divide it by 2, 2 and a half percent.

Â So we issued at par, interest expense equals cash.

Â 6:32

Now lets look at one that's issued at a discount.

Â So here the effective rate or the market rate is 6%.

Â The coupon rate is 5%.

Â So, the coupon rate is paying investors less than the market interest rate and

Â so what happens is the proceeds are lower than the face value.

Â So that's why it's called the discount.

Â So if you remember back in the present value, time value money videos.

Â If the interest rate goes up, the present value goes down.

Â So what happen here is the effective rate has gone above the coupon rate, so

Â the present value goes down below the face value of 10,000.

Â And you should move your hands up and down as you talk about it because I'm

Â doing that here even though you can't see it.

Â Anyway, we debit interest expense for

Â 292 that's the proceeds of 9,729 times the effective rate 6%.

Â Divided by 2 for half a year.

Â [SOUND] We credit cash for 250.

Â That's the coupon payment, which is the face value times the coupon rate, 5%,

Â divided by 2.

Â 7:46

[SOUND] And then to make this balance, we need a plug to bonds payable.

Â It's what we need to make the debits equal to credits.

Â Now what this is going to do,

Â this is foreshadowing what I'll show you in the example in a little bit.

Â By crediting bonds payable, we're making that balance go up so

Â the proceeds of 9,729 we would add 42 to that.

Â And over time it will eventually grow to be 10,000.

Â Which is what we owe at maturity.

Â But you'll see that more when we go through a detailed example.

Â [SOUND] Final example in this slide [LAUGH] is bond issued at a premium.

Â [SOUND] So here the effective rate, the market rate is 4%, the coupon rate is 5%.

Â So, the company's actually giving investors a better deal.

Â They're giving them a higher rate on the coupon than they could get in the market,

Â so the proceeds are greater than the face value.

Â Investors are willing to pay more than $10,000 to get this higher interest rate.

Â Or another way to think about it is.

Â The market rate has gone down below the coupon rate, which means the present value

Â goes up above the face value that inverse relationship.

Â 9:56

So let's go through a detailed example of accounting for a discount bond.

Â So January 1, 2010, KP is going to its three year, 5%, $10,000 face value bond.

Â But now, investors are pricing the bond using an effective or

Â market interest rate of 6%.

Â Because the market rate is 6%, but we're only paying 5%.

Â The market's not going to give us $10,000.

Â They're going to give us less than that.

Â A discount 9,729.

Â So the market rate is higher than the coupon,

Â the proceeds are lower than the face value.

Â Inverse relationship.

Â 10:31

To calculate the bond price, what you could do is use Excel or

Â your calculator or the tables.

Â Plugin a face value or future value of 10,000, a rate of 3%.

Â Which of course is half of the annual rate of 6%.

Â That's the effective rate.

Â Number of periods is six, three years.

Â [SOUND] Payment which is based on the coupon rate.

Â So that's 5% divided by 2.

Â That's 2 and a half percent times 10,000.

Â And you'd come up with a present value 9,729.

Â Now I'm not going to show you that in Excel, I'll leave that up for

Â you to do on your own.

Â [SOUND] But what I want to get to now is what is the journal entry that KP

Â would make when they issue this bond?

Â Let me go ahead and throw up the pause sign and you can try and

Â think about what it would be.

Â [SOUND] Okay.

Â So we're going to debit cash for 9,729 because we're receiving cash for

Â the proceeds, the present value.

Â [SOUND] And we credit bonds payable, the liability for 9,729.

Â So notice, we create a liability that's less than the face value.

Â Even though we're going to to have to pay the face value of 10,000 at maturity.

Â No problem, as you'll see.

Â Eventually, we'll grow that bond's payable so

Â that at maturity it's equal to $10,000, which is what we owe at that point.

Â [SOUND] So to see how this all plays out,

Â it's handy to do one of these amortization schedules again.

Â So when we get to our first coupon payment on June 30th,

Â we have a beginning balance in bonds payable of 9,729.

Â The interest expense is going to be that beginning balance of 9,729 times

Â the effective rate of 3%, so that gives us interest expense of 292.

Â The coupon payment, the cash payment is equal to the face value of

Â 10,000 times the coupon rate, 5% divided by 2.

Â 2 and a half percent to get $250 cash paid.

Â So if you can picture the journal entry in your mind,

Â we're debiting interest expense, crediting cash paid.

Â It doesn't balance, so we need a plug to bond payable of 42.

Â That's the difference between the interest expense and the cash paid.

Â That 42 is going to get added to 9,729 to come up with an ending balance of 9,771.

Â [SOUND] Then you would do that for every six months to maturity.

Â So a couple things to notice here.

Â The cash paid never changes, so the coupon payment is the same every six months.

Â 13:00

Interest expense though gets bigger every six months,

Â because it's based on the balance and bonds payable.

Â And the bonds payable balance is growing over time.

Â The balance and bonds payable is growing over time because our plug to

Â bonds payable gets bigger over time.

Â And if you notice at maturity, the balance and

Â bonds payable is $10,000 which is exactly what we owe at that point.

Â So the accounting [LAUGH] all works out in the end.

Â [SOUND] So,

Â let's practice doing one of these effective interest method journal entries.

Â So I'll put up the pause sign and try to do the journal entry for June 30,

Â 2010, which is the bolded row in the schedule Okay.

Â So we debit interest expense for 292.

Â That's the bonds payable balance times the effective rate of 3%.

Â We credit cash for 250.

Â That's the coupon payment, 10,000 times 2 and a half percent.

Â And we plug bonds payable to make the debits equal to credits.

Â So that's a credit of 42, which increases the ending balance.

Â And then makes the interest expense higher the next period.

Â [SOUND] So now, I want you to try the journal entry for the last period.

Â 12, 31, 2012.

Â And I'll put up the pause sign and you can give that journal entry a shot.

Â 14:26

Okay. So

Â we're going to debit interest expense for

Â 299, which is that last interest expense in the column.

Â We'll also have to pay back the bonds payable balance, so

Â we debit bonds payable for 10,000 so that we can zero that out.

Â We're going to credit cash for 10,250 and

Â we also have the credit to bonds payable at 49, which was the plug.

Â And obviously, you could combine that debit and

Â credit to bonds payable into one entry.

Â I split it apart so it would be easier to see where those two numbers come from.

Â 14:57

>> I remember hearing about something called a zero-coupon bond.

Â Is that related to what we're doing here?

Â >> I bet Timothy Dalton played James Bond in the zero-coupon bond video.

Â >> Yes, a zero-coupon bond is an extreme example of a discount bond.

Â I know I'm taxing your patience enough already, so

Â I'm not going to go through it in detail.

Â But let me just quickly give you and overview of how it works.

Â So in a zero-coupon bond, you would borrow, say, $9,000 and

Â then just pay it back $10,000 at maturity without making any coupons,

Â coupon payments in the interim.

Â So what it's going to look like on an amortization schedule is,

Â there's going to be no cash payments as you go through the bond.

Â So this interest expense will just be equal to the increase in bonds payable.

Â And eventually, will increase the bonds payable up from $9,000 originally to

Â $10,000, which is the cash payment that you make at maturity.

Â So it works just the same, except that there's no cash payments every six months.

Â There's just the repayment of what you owe at maturity.

Â 16:04

So if that wasn't complicated enough, there's a little bit of

Â a wrinkle with discount bonds and the statement of cash flows.

Â When we have bonds issued at a discount, part of the interest expense is noncash.

Â The noncash amount is equal to that plug to bonds payable.

Â So remember the journal entry we did.

Â We debited interest expense for 292.

Â [SOUND] We credited cash for 250 and so we credited bonds payable for the plug of 42.

Â That plug of 42 represents the noncash portion of interest expense.

Â So again, if you think of how the statement of cash flow works,

Â interest expense is part of net income.

Â But we need to adjust that to get to cash.

Â So we have to pull out the noncash part of interest expense,

Â the 42 to get from interest expense to cash.

Â We do that by adding back that 42 in the operating section of this statement of

Â cash flows under the indirect method.

Â This is often labeled something like amortization of bond discount.

Â Now I know we usually use amortization for

Â intangible assets, whereas this is a liability but it's tradition.

Â You don't want to mess with tradition.

Â So this is typically called an Amortization of Bond Discount.

Â The key thing is we've got this noncash interest expense that we need to

Â remove on the statement of cash flows under the indirect method.

Â 17:39

>> Another excellent summary, Paul.

Â Good job.

Â So a quicker way to remember this is any noncash items have to

Â be taken out in the indirect method for SCF.

Â And then any gains or loses related to investing activities or

Â financing activities have to be taken out, as well.

Â And it's nice to have a simple rule like that,

Â because I'm going to keep adding to the list.

Â So I also have an example of accounting for a premium bond.

Â But to be honest with you, very few bonds are ever issued at a premium.

Â The vast, vast, vast majority of bonds are either at a discount or at par.

Â I don't know, there's probably some investor psychology reason behind this.

Â So this is not something that's really important for the real world.

Â I'm going to go through it quickly for

Â completeness to get another review of the mechanics.

Â If you want to go through it more slowly,

Â then I guess just watch it again at half speed.

Â So KP issues the same bond.

Â Three year, 5% coupon, $10,000 face value.

Â But now the market rate is 4%, so the market rate has dropped below the coupon.

Â Which means investors are willing to pay a premium.

Â Proceeds are above face value.

Â [SOUND] You could figure that out through present value calculations.

Â So if you in all the perimeters, what's really changed here is

Â the interest rate is now 2% instead of 3% in the discount example.

Â [SOUND] You would end up with a present value of 10,280.

Â And I noticed I missed the n equals 6.

Â So go ahead and write that in, but, but not on your computer screen.

Â But maybe on the printout for the slides.

Â [SOUND] Anyway, the journal entry on issuance would be debit cash,

Â 10.280 and credit bonds payable 10,280.

Â [SOUND] This is what the amortization schedule is going to look like.

Â First thing to notice is the interest expense is always less than the cash paid,

Â that's because the effective rate of 4% is below the coupon rate of 5%.

Â Of course, the coupon rate, coupon payment is the same every period.

Â And so we're have is our plug to bonds payable is always going to be a debit,

Â it's always going to reduce bonds payable.

Â So over the life of the bond, bonds payable balance gets reduced from

Â 1080 down to 10,000, which is what we owe at maturity.

Â So to do a interest expense entry, you would debit interest expense for

Â 206, taking the June 30, 2010.

Â Credit cash for 250 and then a plug as a debit to the bonds payable.

Â [SOUND] And then at maturity, again debit interest expense, credit cash and

Â then debit bonds payable for the 10,000 plus the last debit for

Â the interest payment of 49.

Â So, it's almost the mere image of the discount.

Â In fact, you could hold the video up to a mirror.

Â And you would see that the premium is the mirror image [LAUGH] of the discount.

Â So let's move on to the next topic.

Â 20:56

The price the firm pays to buy back the bonds are typically different from

Â the book value.

Â And that's going to be the case,

Â because the book value's based on the original interest rate.

Â If the interest rate has moved up or

Â down since then, then the current value will be different from the book value.

Â [SOUND] Gain or loss is going to be recorded on the income statement for

Â the difference between the book value of the bonds and

Â the price we have to buy them back.

Â This gain or loss is going to be backed out of the operating section of this

Â statement of cash flows under the indirect method because it's a financing activity.

Â It's going to look just like the gain or

Â loss on sale of property client and equipment.

Â So we have to remove this from the statement of cash flows.

Â >> Here is another thing.

Â To add back in the operating section of the SCF.

Â But, my question is,

Â why can't the company just pay back the principal to retire the bond?

Â 21:49

>> Yeah, it seems logical [LAUGH] that if you have a $10,000 bond,

Â why not just give the investors $10,000 and be done with it?

Â Well, that's the wrong amount.

Â Because first of all,

Â that $10,000 is how much you owe at maturity at some point in the future.

Â As we've been talking about with time value of money,

Â that 10,000 in future dollars is not worth necessarily, $10,000 today.

Â In fact, it won't be worth $10,000 today if there's any

Â kind of positive interest rate.

Â So investors want what it's worth in today's dollars.

Â Plus, if you're retiring it before maturity, investors are losing those

Â coupon payments that they originally paid for when they bought the bond.

Â And so they have to be made whole for the loss of those coupon payments.

Â So our need to do a present value calculation to figure out

Â exactly how much they'd have to pay to retire the bonds.

Â 22:41

So let's look at some examples of how this retirement before maturity works.

Â So first, we're going to look at the situation where you end up booking a loss.

Â On July 1, 2011, KP decided to buy back it's bonds, which were

Â issued an effective interest rate of 6%, so we're looking at the discount scenario.

Â The market rate has dropped to 4% on this date, so

Â KP must pay $10,144 to retire the bond.

Â Now I'm not not going to go through that calculation but

Â I'll put a challenge out there.

Â So see if you can figure out that calculation and

Â if you figure it out, post to the discussion forum for this video.

Â The first person to post the correct methodology for

Â getting this will win a prize.

Â The prize is I'll post good job under your answer.

Â Anyway, [SOUND] what we have to do is go back to the amortization schedule and

Â see where we are for the balance in bonds payable.

Â So as of July 1, 2011, the balance is 9,858 because we've had three entries so

Â far where we've, where we've increased the bonds payable balance through that plug.

Â [SOUND] So I'm going to put up the pause sign and

Â see if you can record the journal entry for paying the cash to retire this bond.

Â 24:03

So we want to debit bonds payable for 9858, so

Â we want to zero out that balance and bonds payable, because we're retiring it.

Â We want to credit cash for 10,144,

Â which is the cash that we're paying investors to buy back the bonds.

Â We need a plug,

Â the plug is loss on retirement which will go on the income statement.

Â Now, next, let's look at a gain scenario.

Â So the same bond, same discount, effective interest rate of 6%.

Â Now when we want to buy it back on July 1st, the market rate has climbed at 8%,

Â so KP has to pay 95 584 to retire the bond.

Â Same challenge.

Â See if you can figure out where I got that number and

Â post it to the discussion forum.

Â So, bringing back up our amortization schedule it's the same as before,

Â up until July 1st, we've been amp, we've been working on the bond.

Â Plug in bonds payable.

Â The balance is 9,858.

Â So on July 1, 2011, what is the entry that would be made to retire this bond?

Â 25:35

>> Wait.

Â It looks like the company got a gain because interest rates went up.

Â Isn't an increase in interest rates bad news?

Â Isn't a gain good news?

Â This is almost as confusing as the plot from Quantum of Solace.

Â >> Yeah. So

Â when you retire a bond before maturity, you're essentially marking it to market.

Â You're marking it to fair value.

Â And anytime you mark liabilities to fair value, you enter this bizarro world

Â of accounting, where in an increase in interest rates is bad news.

Â But it shows up as a gain.

Â A decline in interest rates is good news,

Â that's what we saw earlier, but it shows up as a loss.

Â So you can't view gains and losses on these fair value of liabilities or

Â these retirements before maturity as good news or

Â bad news, because they don't have that same interpretation.

Â And what's even crazier is some companies voluntarily carry their long term debt

Â on a fair value basis and so they have these bizarre gains and

Â losses all the time, as I'll show you in the next slide.

Â [SOUND] Okay.

Â One more topic, one more slide and we'll wrap this up.

Â So under both U.S.

Â GAAP and IFRS, companies have the option to measure long-term debt at fair value,

Â the market value, rather than at amortized cost using historical market rates.

Â So basically, all that accounting that we've been looking at so far.

Â You don't have to do that if you choose to do this fair value option.

Â 27:03

You might do that because under amortized cost,

Â the book value of long-term debt on your balance sheet can deviate substantially

Â from what the current fair value is.

Â And what happens is if you then decide to retire your bonds, all of that gain or

Â loss hits the income statement immediately.

Â But what would happen under the fair value option is

Â you would recognize those unrealized gains and losses every quarter, because

Â you'd adjust the book value of long-term debt to reflect the current market value.

Â [SOUND] So if the market value of your debt went up,

Â you would book an unrealized loss and a credit to bonds payable.

Â Credit to bonds payable increases the balance to the current market value.

Â We offset that with a debit on realized loss and

Â if there's a decrease in market value, you have to reduce your bonds payable account.

Â Debit bonds payable and credit an unrealized gain.

Â 27:54

Now what happens is financial services firms,

Â like banks are the only ones that tend to do this in any large numbers.

Â And that's because they're hedging other kinds of fair value explosion.

Â The balance sheets of these unrealized gains or losses may cancel other

Â unrealized gains and losses elsewhere, as everything's marked to market value.

Â Non-financial firms, so firms that are not banks almost never elect this.

Â Because they don't want their net income to be volatile based on

Â changes in the value of their bonds, if they just intend to hold them and

Â then pay them off at maturity.

Â