For one of the questions in Qbank, it is mentioned that the cash flow from operations for a premium bond is understated and cash flow from financing is overstated than a par bond. I get the financing part, but how is the cash flow from operations understated?
See the response posted by Beatthecfa in below thread. He has a very nice explanation there. Because Interest Expense reported for Premium Bond is lower (because of subtracted amortization) than the actual Coupon Paid, CFO is understated. http://www.analystforum.com/phorums/read.php?11,1051272,1052420#msg-1052420
Sorry jimmykaw, the above explanation is not so complete. For a Premium Bond, 1. Interest Expense is lower, which is Coupon Payment - Amortization of Bond Premium. 2. But since, Amortization is a non-cash charge, it is not included in calculation for CFO. 3. And we know that for a Premium Bond, Coupon Rate is higher than that for a Par Bond. 4. So, in calculation of CFO for a Premium Bond, only thing which is considered is its Coupon Payment. Which we know is higher than what it would be for a Par Bond. 5. So, with higher deduction from CFO for higher coupon rate, CFO becomes less and is thus understated for a Premium Bond.
Thanks rus1bus, that helps. I was not considering the fact that coupon payments are outflows so would decrease operating cash flows (and not increase them).
Yes, jimmykaw, that is a very valid confusion. It is easy to take yourself as Bond Holder and not a Bond Issuer. But, to avoid this confusion, If company is holding a bond, then it will be categorized under one of the three securities; Held to Maturity, Marketable Securities and Available for Sale. That is, it will have another Accounting Treatment. So, if it not directly mentioned in the question as to whether company is holding the bond or issuing it, it may be interpreted from what they are asking in the question.
can you explain the financing part as well?
Regarding the Financing part (CFF), when you issue a Premium Bond, you get more funds in your company as against when you issue a Par Bond. So, your Cash Inflows in CFF get inflated by the Premium Amount and hence are overstated. Financing part is easier to analyse and remember. In the exam, you may not want to spend much time in analysis. So, it will help if you can quickly get the financing part and do reverse for the Operating part.