# Why it is important to determine selling of bonds

Case1: Chuck Norris co.

A)Selling price of bond

The determination of the selling price of bonds is important because it helps the bondholders know the yield they will receive if they were to purchase the bond.

Bonds can be issued at par, premium and at a discount. A Bond is said to be issued at par if the yield is equal to the coupon rate. If the current market yield is more than the coupon rate stated on the bond, then, that bond has been issued at premium. If the coupon rate is more than the yield rate currently earned by similar bonds in the market (Sheth, 2007, Slide 23, chapter 12)

Bondholders receive periodic payments of interest amount, which is constant over the life of bond. Therefore the price of the bond is arrived at by discounting all these payments i.e. the selling price is the present value of all periodic payments plus the present value of the maturity amount, which is the principle amount of the bond. (Englard, 1992, Page 6, chapter 1)

The formula for calculating the price of the bond is as shown below.

Bond price= (PV) =p (1+r)-2 + p (1+r)-2 +…. +p (1+r)-n + m (1+R)-n

Where =p= period receipt/payment

r=required yield –effective

M=maturity value (principle amount)

The periodic receipts of interest amount are constant over the bond period and therefore are annuity in nature.

Therefore to calculate the present value of the interest payments the annuity formula is used.

Present value interest payments=                    Constant interest receipts* (1-(1 +r) –n

r

The maturity amount (principle) is received as a single amount at the end of the bond period, thus is a single amount discounted using the single amount formula.

Present value maturity value =m (1+r)-1

Therefore, the total selling price is the sum of present value of interest and principal amount.

2) Presentation of bonds in balance sheet

When a bond is issued, the following factors are considered in accounting for the bonds.

– Recording the issue or purchase of the bond

– Recording the interest received during the life of the bond.

-Accounting for the retirement (through calling, refinancing or conversion) of the bond. (Sheth, 2007, Slide 16, Chapter 12)

Issuer’s books

As seen earlier bonds can be issued at par, discount or premium.

Bond issued at par– the bonds were issued between interest dates.

Long-term liabilities.

Bond payable                                      xxx

# Current liability

Interest payable (1 month)                  xxx

# Current assets

Cash (amount of bond)                       xxx

# Bond issued at a discount

Long-term liabilities

Bonds payable                                                xxx

Discount on bonds payable                 xxx

# Current assets

Cash (less discount on bond)              xxx

# Bonds issued at a premium

Long-term liabilities

# Investors books

The buyers’ balance sheet will be as follows

# Assets

Investments in bond                           xxx

# Current-asset

Interest accrued (1 month)                  xxx

Cash (amount of bond)                       xxx

# At discount

Assets

Investment in bond (less discount)     xxx

# Current assets

Cash                                                    xxx

Assets

# Current assets

B) Income statement items

The items that will be included in the income statement of Norris co. for the year 2008 include

-Interest expenses

Interest expenses

The amount of interest is determined using the par value and the coupon rate and not effective rate. (Englard, 1992, page 2-3)

Illustration

# At par

Using the example of Norris co. bond assuming that it was issued at par, then the interest will be 1000*xx%= interest

# At discount

Payment- interest = xx%*1000

Interest amount = yy% *(1000-discount)

The difference between the interest payment and interest amount is amortization of discount.

Interest payment =xx% * 1000

Interest amount= yy% * (1000 +premium)

The difference between the interest payment and the interest amount is the amortization of premium

If the selling price/issuing price of the bond is higher than the par value, then is issued at a premium while if issued at a lower price than the par value, then, it is at a discount.

The discount or premium on issue is amortized over the life of the bond using either the straight line or effective interest rate method.

Life of bond

# Effective interest rate

Interest payment = xx% *1000

Less: interest amount = (yy % * (1000+ premium)

Interest amount = yy% * (1000-discount)

Less: interest payment = (xxx% /* 1000)

Discount amortization             xxx

C) Discount on issue

When the bond is issued at a discount, the issue amount is lower than the par value. The redemption/maturity amount is equal the par value.

Therefore the amortization is used to increase the bond book value over the life of the bond. All the discount will be amortized over the life of the bond and the amount on maturity will be= (discount + discount issue price)

Illustration –amortization table

A                      B                    C                       D

(yy % * disctd.amt)    (xx%*1000)    (A-B)=C          D=(C+ Book value)

Period interest amount interest payment discount amortization   bond book value

0                      –                       –                       1000-discount             discounted amount

1                      xxx                  xxx                  A-B                             D+ (A-B)

The amortization amount is used to increase the interest expenses in order to reflect the extra interest paid to the bond holder (Englard, 1992, page 8 paragraph 1).

D)Reporting retirement of bonds

Bonds can be paid up before its maturity date usually at a specified price. If the price is more than the book value of the bond then, the difference is a loss on retirement while if paid amount is less, then, it is a gain.

Gains and losses on retirement are treated as extra ordinary items in the income statement.

The book value of the bond is equal to the value minus any discount if the bond issued at a discount or plus the premium if the bond was issued at a premium.

The amortization of the premium or discount should be up to the retirement date.

The retirement of the bond leads to the closure of the bonds payable account, any premium discount and the cash is reduced by the amount of the bond balance. And the loss or gain on retirement is recognized in the income statement (Englard, 1992, page 7, paragraph 1)

It is important to note also any bond costs should be amortized over the life of the bond. Upon retirement, any unamortized bond costs are written off in the income statement.

Case 2, Iroquois corp.

# A (i) recording of equipment at \$ 100,000

Assets and liabilities are recorded in the books at the cost incurred to acquire the asset or liability (original cost). This is a requirement under the US GAAPs

The historical cost in this case includes the purchase price and all other incidental costs that enable the asset to be used by the company. Some of the incidental costs are legal fees, transportation, installation and pre-installation set up costs.

The advantage of recording assets using historical cost is that it resolves the inconsistencies as to what amount to record if fair market value was to be used (Mukherjee, Hanif, Financial Accounting 1.11)

Any discount on acquisition should be subtracted from the purchase price. In case the asset is acquired for a consideration other than cash e.g. shares, bonds, then, the fair market value of the shares, bonds should be the cost of the asset.

Subsequent costs to improve the asset should be capitalized as long as the additional costs leads to the increment of useful life of the asset and leads to increased productivity.

In the question, recording the asset at \$ 100,000 is wrong and is not in line with GAAP provision of recording the asset at the price actually paid for the asset (\$200,000)

The \$ 100,000 is only part of the total cost of the equipment. The total cost must include the valuation of the Treasury stock. Treasury stock should be valued at the fair market value.

2) Recording equipment at & 175,000

The cost of the equipment if it was to be bought using cash is \$ 175,000. However, the cost increased to \$ 200,000 because of the use of & 100,000 treasure stock part of the payment.

Therefore the amount to be recorded is \$ 200,000 i.e. the cash price plus fair value amount of Treasury stock of \$100,000. Recording the cost of the equipment at \$ 175,000 will be inconsistent with the historical cost principle and generally accepted accounting principles (GAAPs) (Charumathi, Virayakam, 2004, page 17)

3) Recording equipment at \$ 200,000

Recording the acquisition of the equipment at \$ 200,000 being \$ 100,000 cash and \$ 100,000 treasury stock is the correct historical cost of the asset.

The total in this case should be the cash payment and fair value of Treasury stock of \$100,000 and \$100,000 respectively.

The cash price of \$ 175,000 is irrelevant now because the asset was not wholly acquired using cash and therefore recording the cash price is incorrect.

Any change in the fair value of the treasury stock should however be accounted for separately.

# B.) Treatment of balance

i) Treatment of balance as liability

A liability basically is that obligation which legally binds a company or individuals to pay a stated amount of debt.

Liabilities can be short term e.g. accounts payable, accrued expenses and long term liabilities e.g. loans and bonds. Current liabilities are due within one year where as long term liabilities are due after more than one year.

Based on the above description, therefore, the balance which is to be repaid using Treasury stock over a period can be treated as a liability. Precisely the part that is due within a year is current and that due after one year is long term.

The obligation to pay the balance using treasury stock is also in the purchase agreement. This means that the company is legally bound to pay the debt using Treasury stock and as seen above a liability is an obligation that legally binds one to pay the debt hence the balance can be treated as a liability.

The other aspect of a liability is that it is an obligation incurred in the past transactions and the payment is at a future date. The balance is as a result of the past transaction of acquiring the equipment in which the balance is to be paid over a period of four years. In this respect therefore the balance qualifies to be treated as a liability.

ii) Treatment of balance as treasury stock subscribed

Treasury stock is shares that the company issued and reacquired so that they can be retired or re-issued again. The Treasury stock is treated as reduction in shareholders equity thus the reason why Treasury stock is a negative number in the balance sheet. (Sheth, Slide 23,   2007)

The issue of the Treasury stock as part of the payment for the acquisition of the equipment is equal to the selling of the shares and therefore the share capital is either increased or decreased with the amount depending on the issue price.

Since it was agreed that the balance was to be cleared using the Treasury stock then it is prudent that the share capital is either increased or decreased with the amount of the balance.

Another reason for treating the balance as Treasury stock subscribed is that the shares were earlier on re-acquired with the intention that the share price will increase and thereby reducing the number of shares to be issued to clear the balance.

Case 3 (FAS B. 115)

A)    This statement deals with equity investments with fair values that can be readily determined as well as all investments in debt securities.

These investments are classifieds in to three i.e. held-to-maturity, trading securities and available-for-sale securities. (FASB 115, paragraph 2, 3 and 4)

Available-for-sale securities are those that do not fit the description of held-to-maturity and trading securities. They are reported at fair value with unrealized losses or gains excluded in the income statement but reported as a separate component of equity.

Held-to- maturity are those that the company wishes and intends to hold until they mature. They are reported at amortized cost (FASB 115, Paragraph 2)

Trading securities are those bought solely for disposal in the short term. These securities are recorded at fair value with the gains or lose being taken to the income statement.

i) Availability for-sale securities

The advantages of a company investing in available-for-sale securities are as elaborated below

The availability-for-sale securities can be sold any time i.e. they are very liquid and therefore it is beneficial to the company in case it encounters cash flow problems as compared to borrowing.

Securities in the available-for-sale category usually have a tight spread as compared to the index and this therefore enables the holder to buy other cheaper securities from the money realized (Hullis, May 8, 2006, Para 2)

# Held-to-maturity

A company would want to invent in held-to- maturity securities simply because capital appreciation purposes. Most securities held over the long term usually appreciate in value and therefore the company benefits in the long run.

The company may also want to earn constant income over the investment period. Held-to-maturity securities can be bonds, which promise constant returns until maturity.

These securities are purely held by the company for speculative purposes i.e. they are bought when the prices are low and sold off when they appreciate. The company benefits from the appreciated value.

2) Separate accounts

Available-for-sale, held-to-maturity and trading securities are recorded in separate accounts primarily because of the different accounting treatment accorded to each.

FASB 115 calls for the different treatment of these investments.

Held-to-maturity securities are reported at amortized cost according o FABS 115. Held-to-maturity securities include debt. The periodic interest payments are recorded in the income statement as income.

The security amount is amortized over life of the asset with the balance at the end of the year being recorded in the balance sheet.

Trading securities are reported at fair value with any gain or loss unrealized being taken to the income statement. Fair value is the market value.

Available-for-sale securities are reported in the balance sheet at fair value with unrealized gains or losses being recorded as a separate component of equity.

From the above analysis therefore it would present challenges if al the three classes were to be recorded in the same account because of the different accounting treatment for each. (FASB 115)

B)    (i) Classification of assets.

The liquidity of the investment is one of the factors used in security classification. Trading securities and available-for-sale securities should be liquid so that they can be disposed-off easily when the cash is needed.

The nature of security return is also considered in designing securities. Most held-to-maturity securities have constant returns. Bonds and other forms of debt instruments fall in this category.

Time period of the investment is also a factor that is considered. Trading securities and available-for-sale can be sold at any time while held-to-maturity can be redeemed at the end of the period or after some time if the contract provides for an early retirement.

ii) How factors affect unrealized losses

Unrealized losses is to be reported in the income statement for trading securities because they can be disposed off at any time while available-for-sale it is recorded as a separate component of equity because these investments can be sold if need be but not as easily as trading securities.

iii) Availability-for-sale securities

Unrealized losses are to be treated as a component of equity but as a separate item

Held-to-maturity

Amortized over the useful life of the asset

Recorded in the income statement

Reference:

FASB (1993) Summary of Statement No. 115.Accounting for Certain Investments in

Debt and Equity. Retrieved on 25/1/2008 from

http://www.fasb.org/st/summary/stsum115.shtml

Hollis, E. (2006) Making Securities “Available for Sale” Retrieved on 25/1.2008 from

http://www.cunacfocouncil.org/news/819.html

Englard, B. (1992) Intermediate accounting II: Long-term Liabilities.New York. McGrawHill-

Professional

Mukherjee, A., &Hanif, M.  Financial Accounting: Accounting Concepts and Conventions.Tata

Mc Graw Hill

Charumanthi, B., & Virayakam, N. (2004). Financial Accounting. Accounting principles,

Accounting Concepts.New Delhi. S. Chand

Sheth, S. (2007). Intermediate Accounting 16E: Debt Financing. Retrieved on 25/1/2008 from

http://instructor.mstc.edu/instructor/jkruziki/ACCTIII/ch12-A.ppt