for debt at discount and premium, what is the actual interest expense? the debt at issue market value * at issue market yield? or the face value * coupon rate. when interest expense reduce CFO, it reduce by the amount of face value * coupon rate or it reduce by market value * at issue market yield? because there statement about premuim bond, CFO understaed, and discount bond, CFO over estimated. it refer to payment for interest by using the face value * coupon rate or the market value * yield at issue? Thanks
Here are some rudiments of bond accounting: 1. Record the initial balance sheet liability as the present value of the future payments, discounted at the market rate at issuance (not the coupon rate). 2. Record interest expense as the rate in effect at issuance times the book value at the beginning of the period. 3. Adjust book value of the liability in each period by the difference between the cash coupon payment and the interest expense calculated in 2 above. 4. Under accounting rules, the cash coupon payment is a CFO outflow. However, the analyst should correct for this and record the interest expense (calculated in 2 above) as CFO outflow and the amortization of premium (calculated in 3 above) as CFF (it could be a CFF inflow or an outflow depending on whether the bond at a premium or discount). 5. In a premium bond, coupons are most likely at a rate higher than the market rate of interest at issuance, so deducting the high coupons from CFO causes CFO to be understated. Example: imagine issuing an annual 4 year, 50% coupon, $1000 face bond when the market rate equals 5%. The balance sheet liability would be $2,595 and the cash coupon payment would be $500, coming out of CFO. But really the interest expense should be 5% of $2595, or $129.78; the remainder is amortization of premium and should come out of CFF. 6. In a discount bond, coupons are likely at a rate lower than the market rate of interest at issuance, so deducting the low coupons from CFO causes CFO to be overstated. 7. The most extreme case of CFO overstatement is the zero-discount bond. Since it has no coupons, nothing is deducted from CFO, though clearly the borrower is paying an implicit interest cost.
thanks very much for the detailed explaination. for know the most procedure. I am curious about the actual payment. what is actually flowed out of borrower’s pocket? the interest expense after adjusted for amortization of premium/discount? or the coupon rate * face value? if the amortization of premium is out of CFF, it is substracted from CFF? so , it will reduce the balanch sheet liability of the premium bond? for amortization of discount, is it added into CFF? so the added amount will be added back to balance sheet liability of discount bond, so balance sheet liability increase to par at maturity? what I feel confused is the sign, is the amortization amount always positve or depends? what is the actual cash flow out of borrower’s pocket and into the lender’s pocket? Thanks. chebychev Wrote: ------------------------------------------------------- > Here are some rudiments of bond accounting: > > 1. Record the initial balance sheet liability as > the present value of the future payments, > discounted at the market rate at issuance (not the > coupon rate). > > 2. Record interest expense as the rate in effect > at issuance times the book value at the beginning > of the period. > > 3. Adjust book value of the liability in each > period by the difference between the cash coupon > payment and the interest expense calculated in 2 > above. > > 4. Under accounting rules, the cash coupon payment > is a CFO outflow. However, the analyst should > correct for this and record the interest expense > (calculated in 2 above) as CFO outflow and the > amortization of premium (calculated in 3 above) as > CFF (it could be a CFF inflow or an outflow > depending on whether the bond at a premium or > discount). > > 5. In a premium bond, coupons are most likely at > a rate higher than the market rate of interest at > issuance, so deducting the high coupons from CFO > causes CFO to be understated. Example: imagine > issuing an annual 4 year, 50% coupon, $1000 face > bond when the market rate equals 5%. The balance > sheet liability would be $2,595 and the cash > coupon payment would be $500, coming out of CFO. > But really the interest expense should be 5% of > $2595, or $129.78; the remainder is amortization > of premium and should come out of CFF. > > 6. In a discount bond, coupons are likely at a > rate lower than the market rate of interest at > issuance, so deducting the low coupons from CFO > causes CFO to be overstated. > > 7. The most extreme case of CFO overstatement is > the zero-discount bond. Since it has no coupons, > nothing is deducted from CFO, though clearly the > borrower is paying an implicit interest cost.
The cash flow is the coupon payment. You are right that the amortization can be positive or negative. It depends whether you have a premium bond or a discount bond. A premium bond’s book value is reduced over time until maturity; a discount bond’s book value is increased over time until maturity. Decreases in the premium bond’s book value should be considered CFF outflows, and increases in the book value of the discount bond should be considered CFF inflows. Note that the preceding discussion concerns the optimal analytical treatment, not accounting rules. Under GAAP, simply deduct the cash coupon payment from CFO, increase CFF by the proceeds at issuance and decrease CFF by the amount repaid at maturity.