Bonds refer to the contractual promises made by a company to pay its lenders or bondholders cash in the future in exchange for receiving cash in the present.
Generally speaking, bonds involve promises to make two types of future cash payments to bondholders: the face value of the bond, and periodic interest payments.
The face value of a bond, otherwise referred to as the principal, par value, stated value, or maturity value, is the amount of cash that is payable to the bondholders when the bond matures. The periodic interest payments, on the other hand, are made based on the interest or coupon rate which is promised in the bond contract being applied to the bond’s face value.
A bond’s future cash payments are discounted to the present, using the market rate of interest, to arrive at the bond’s market value. The market rate of interest refers to the rate demanded by bondholders given the risks associated with a bond’s future cash payment obligations.
If the coupon rate when a bond is issued is higher than the market rate, the bond is said to be selling at a premium as its market value will be higher than its face value. Conversely, if the coupon rate when a bond is issued is lower than the market rate, the bond is said to be selling at a discount as its market value will be less than its face value.
Initial recognition, initial measurement and subsequent measurement of bonds
The cash received or sales proceeds when a bond is issued is reported as a financing cash inflow on the issuing company’s statement of cash flows. Additionally, bonds payable are usually measured and reported at the sales proceeds on the issuing company’s balance sheet at the time of issue i.e. at the face value of the bond less any discount, or plus any premium.
The following three-step approach can be used to account for bonds that are issued, whether at face value, at a premium or at a discount to face value:
- Identify key features of the bond and the market interest rate necessary to determine sales proceeds;
- Determine future cash outflows (i.e. interest payments and principal repayment); and
- Discount the future cash flows and sum their present value to obtain the value of the bonds and therefore the sales proceeds from issuing the bonds.
A company issues $100,000 worth of three-year bonds when the market interest rate on bonds of comparable risk and terms is 4% per annum. The bonds pay 5% interest annually. The sales proceeds of the bonds when issued is closest to?
The correct answer is C.
Key features of the bond are as follows:
Face value, FV = $100,000; time to maturity, n = 3 years; coupon rate = 5%, market rate at issuance, i = 4%; frequency of interest payments = annual; interest payments, PMT = $100,000 * 5% = $5,000.
Therefore, using a financial calculator, sales proceeds or market value of the bond, PV = $102,775.
A company issues $10 million of bonds at face value. A year later the company decides to retire the bonds. If the market discount rate at the time of retirement is less than the market discount rate at the time of issuance, the amount of money paid to retire the debt would be:
A. Exactly $10 million.
B. More than $10 million.
C. Less than $10 million value.
The correct answer is B.
The company would pay the market value of the bond. As the market value of the bond is negatively related to the market discount rate, a decrease in the discount rate would increase the market value. Hence, the company would pay an amount higher than the bonds’ face value.
Reading 31 LOS 31a:
Determine the initial recognition, initial measurement and subsequent measurement of bonds