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In this lesson, we're going to start with a very simple example of a bond so

that you get to see the basic principles.

And then gradually,

we'll be adding more complexity with additional features like a discount, or

a premium, or a conversion feature, or having it issued between dates.

We'll build upon this simple structure that we start with

right now just to give you the basics of bond accounting.

Again, this is ignoring a lot of other costs and

complicating factors, but it's a good place to start.

So let's take an example, January 1, 2017,

Padre Pizza issues $10 million of bonds at 6%.

So 10 million is the face amount, or the par value, of the bonds.

6% is the stated interest rate.

Since there's no discounted premium, that's also the effective interest rate.

The interest rate will be payable semi-annually, that's twice a year,

on June 30th and December 31st for 10 million.

Notice we had it issued on January 1st, 2017 to make the math easier.

In my experience, not a lot of bonds are actually issued on January 1st for

some reason.

Yeah, it's a holiday.

But again, you'll see this a lot in accounting problems.

So what is the interest that'll be paid semi-annually?

So how much is the semi-annual interest?

Well, the interest that will be due on June 30th and

December 31th is going to be my stated interest rate of 6%.

We can adjust it for the fact that it's only half a year.

Here I'm using the 360 day convention.

I've got 180 divided by 360.

You could also just divide it by 2.

But it's 6%, or 6% times one-half a year times the carrying amount,

which in this case is equal to the par value of 10 million,

and I would have $300,000 of interest payable every six months.

So let's go out to Excel and take a look then, and

see how that's going to amortize out through the loan, and

what the payment structure's going to look like, do a little math.

In this segment, we're going to put together a bond amortization schedule.

And it's a little bit more complicated than the spreadsheet that we did

in our first module where we were making an accrual for a current liability.

But I think you'll find the skills that you'll learn to put

this together to be useful in a wide variety of applications.

So let's take a look at what we've got.

Our problem is Padre Pizza.

They've issued bonds at $10 million worth of bonds at January 1st,

2016 that mature in eight years on 12/31/2023.

Now they pay interest semi-annually, a very common occurrence.

Usually the bonds pay interest either quarterly or semi-annually.

They have a stated interest rate of 8%, but they were sold for 10,200,000.

So were the bonds sold at a discount or a premium?

Well, you've got more than the stated amount of the bonds, that's a premium.

So let's put together a little data table, again, just like we did for

the current liability, to put all our variables in it.

So let's start by entering the principle over here, and

the principle is $10 million.

This is the stated amount on the bonds, and

sometimes it's referred to as the par value.

The number of periods, well, it's eight years, but

the bonds pay interest semi-annually.

So you would have two periods a year, so the number of periods is going to be 16.

It's the number of years times you pay interest during the course of the year,

and then the rate that we have.

Well, the stated rate of the bonds is 8%, so we'll put that in here.

That means that the semi-annual interest, and

we'd already put in a little formula to multiply that, is going to be $400,000.

That's how much cash is going to be paid twice a year by

the issuer of the bonds to the lucky person that's holding the bonds.

So the carrying value, we're going to calculate now.

As we pointed out in our slides, it's going to be a present value calculation.

So let's go over here, and we're going to calculate the present value.

Let's do it of the interest first.

So the present value of the interest,

let's use the present value function within Excel, so that's =pv.

And you can see that you need to enter in the rate,

number of periods of payment, and the fair value.

So the rate is going to be 8%.

Let's point to the effective rate here.

But divided by two because it's paid semi-annually, or

you could do 180 over 360, it's the same equivalent, times 180 over 360.

And then the number of periods is going to be 16, so

let's point to here, to the periods.

And then the payment is going to be 400,000,

the amount of interest that we just calculated is going to be paid.

And then we're done, so let's close that.

And we have a present value of 4,660,000.

Now Excel looks at this from the point of view of an investor, so

it came back with a negative number.

We want to deal with a positive number, so let's go back in and

put a negative sign in front of the number of the payments

because they're actually being payments out.

So that gives us a present value for

the interest portion of what we're going to pay on the bond, so 4,660,000.

Now let's do the same thing for the principle,

because at the end of the 16th period you not only

get the 400,000 if you're the investor, you also get your 10 million back.

If you're the issuer, at the end of the 16th period you not only have to

pay $400,000 of interest payments in cash, you also have to pay back the principle.

So that's going to be the present value calculation again.

So let's use PV.

Again, the rate is going to be our effective rate divided by two.

The number of periods is still 16.

Now the payment this time is 0 because there is not a series of payments

that are going on.

So this is a difference between having the interest rate,

which is a series of payments, you enter them in the payment,

or trying to get the amount at the end of the period.

So we've got 0 there for the payment, but

now that future value is going to be $10 million.

So we'll point to the principle up here, and that's it.

We can close that out.

And I'm sorry, we should've done negative in front of the 10 million.

So let's go back and fix that.

And what we've got now, go ahead and click Enter,

is you can see that the present value of the principle and

the interest is $10 million.

Now that's a great way to see that you've done the equations right because right now

we're using the 8%, which is the stated value.

And in a bond issue, the present value of the bond should always be equal to

the stated amount of the bonds when you're using the stated interest rate.

But what happened here is that we didn't have,

An amount equal to $10 million at issuance.

Instead, we had a premium.

The investors were willing to pay us more for these bonds.

That means that market interest rates must have been less than

8% because the market is willing to pay us a premium.

So how do we calculate the effective interest rate

when the bonds were issued at a premium?

Well, one way we can do that is to use a function in Excel called Goal Seek.

It's really cool. You'll find that in Data up here.

So if we go over to Data, and we go over to What-If Analysis, and

we can select Goal Seek.

Now we've got the cursor on a cell that's blank right now, so

it's going to say what do you want to do?

Well, we want this cell right here to be 10,200,000,

so we want to click on this cell.

Not that one, that one.

And we want to put it at a value of 10,200,000.

You can't put a formula in this cell, unfortunately.

And that will be by changing the cell up here with the effective rate.

So click on that and hit OK.

And it does its magic, and it comes back and

tells you that the effective rate on this, with a premium, is actually 7.66%.

So now we've got the carrying value of the bonds at 10,200,000.

Let's put that in here.

And we know now that the premium on the bonds is going to be 10,200,000

minus 10 million, or $200,000.

That is the premium on the bonds.

So now, we've already done an amortization table for you.

We're going to show it to you right now and

see how this works out through the course of the bonds.

We're going to start with our carrying value here at the top.

All right, I'm going to go back to inking again.

So we've brought our carrying value down and put it here.

The payment, here's our stream of payments, it's $400,000 for

all 16 periods.

And then at maturity we're having the $10 million payment,

so the net carrying value at the end will be 0.

In the meantime, we have $200,000 of premium to amortize.

We're going to do that according to GAP, using the effective rate.

So what we do, each period is we take the carrying value and

multiply it times the effective rate.

And you can see how that works if you go on Interest.

There's a cool feature also in Excel called See Precedents,

so let's go back to that.

I think it's in Formulas, and you can click on that and

Trace Precedents, let's do the precedents for the interest.

Trace Precedence, and

you can see that it's our effective rate times the carrying value.

If you go down to the next line and do the same thing,

you'll see it's just the new carrying value again times that effective rate.

So let's clear our arrows and go back.

This will go all the way down.

Now you know you've done this right, this is another self-check.

If you get to the end of the amortization table, if you get to the end,

let's go back to review and start inking, sorry.

If you get down to the bottom and

this amount equals your face amount, this is another self-check.

I've done it right.

I've calculated the proper effective yield.

This is the effective interest method.

It's required by GAP.

The fact we have a premium

means that the effective rate is going to be different from the stated rate.

I know it's going to be lower because when there's a premium,

the market rates must be lower than the stated amount on the bonds.

So let's go back and look.

What do I do now that I've got all this wonderful information?

I can prepare my journal entries.

My first interest payment is going to take this interest

rate from the top of the amortization schedule, and

that's going to be my interest expense.

The amortization here is the difference between the amount that I paid and

my effective interest rate.

It's the difference between the two.

There we go.

I would need that amount to make this journal entry balance in any event, and

here's my cash paid.

So there's my payment for the first period.

Each period I will just take those amounts the same way.

When I get down to the end, here's my interest payment for the final payment.

Notice the interest rate has gone down because this is

a case of the interest is front-loaded into the earlier years

of a bond payment, right?

Because the balance that I'm amortizing on is larger and

it's declining down to 10 million.

It'll go the opposite direction if I have a discount, by the way.

It'll be increasing over time, as opposed to decreasing.

Here's my amortization in the final period.

And there's my cash amount, which is constant, of course,

throughout the term of the loan, and then bonds payable and cash.

I pay off the bonds, I'm done.

So this is a simple table.

It shows you though a couple of different really important things.

One, how to calculate an effective rate of interest,

how to document your bond payments.

Your auditors will be grateful.

You will be grateful if you need to go back and change it.

We should be able to enter in revised rates here and change this bond.

You will be able to use this tool.

If you ever worked on a bond issue, things change daily almost.

The amount of that's going to be issued for, the effective interest rate changes.

This sort of tool will help you keep on top of

the financial implications of a bond issue all throughout the process.

Here's what we'll do with those amounts we just calculated.

Now on issuance, we're going to record the receipt of cash and

the issuance of bonds payable.

No discount, no premium, no initial cost,

strictly at par, $10 million.

Okay, so remember, this program was structured to be simple.

It's not realistic, but sometimes this is what you will see in accounting problems.

So what will the interest payment look like?

Let's do it under two scenarios, one in which you're preparing interim statements,

and one in which you're not preparing interim financial statements.

Let's start with the no interim financial statements first.

On June 30th, I will debit my interest expense for 300,000 and credit cash.

There's my interest.

Well, what if we're issuing interim financial statements?

That means that March 31st, I'm going to have accrued interest.

Well, that's going to look like this.

March 31st, I'll debit interest expense for half of the amount.

Why? Because it's three months of the six

months, of 150,000, and the interest payable for 150,000.

And then June 30th, when I get to the second quarter,

I'll have interest expense for that quarter.

I'll have an interest payable from the previous quarter,

and pay the cash of 300,000 out.

Note that the payments are for interest only.

This type of bond pays interest during the term of the bonds, and

the principal is paid in a lump sum on maturity.

So what happens when we get to the end of the term of the bonds and I pay them back?

Well, I debit Bonds Payable for $10 million, and

I will credit Cash for $10 million.

So this is the simplest type of bond entry.

You should be very comfortable with what's going on in this because it gets more

complicated from this point forward.

Thank you.

Bonds: The Simple Case

Accounting Analysis II: Measurement and Disclosure of Liabilities

Meet the Instructors