i am pretty confused by the term “interest expense” and the effective rate method of amortisation.
Why would this be an expense to the bond issuer if say they issued a bond at par with an annual coupon of 5.5% and the market interest rate rises to 6%?
My understanding is that the issuer is only obliged to pay fixed coupons at 5.5% afterall so there should be no impact on the movement of the market interest rate after the bond is issued.
As an example:
On 1st Jan 1999, ABC company issues US$1,000,000 face value 5-year bonds to be paid each 31st Dec. The market interest rate is 6%. Using the effect rate method of amortisation, ABC is most likely to record:
<> a liability of US$928,674 on the 31st Dec 1999 balance sheet.
I understand how this amount is being derived but i just do not understand the significance of this to the issuer.
You’re absolutely right about the obligation to pay 5.5% of the face value of $1 mm. Since market rates are higher than the coupon, though, the company only receives the $928,674. They’re still paying the $55,000 coupon, but they received less than face value because of the market interest rate. Therefore, the actual expense is higher.
The issuer records the interest expense on the income statement. In the case of the discount, it credits its cash account of (coupon rate*par value), and the rest (the amortization) is credited to the long term debt every year to reach the nominal value when the amortization is 0. Its the opposite for the premia.
the Bond was issued at a discount at $928,674 but at the end of the term the issuer ( borrower) will have to return $1,000,000. the difference Between 1,000,000 - 928,674 = $71,326 will have to be paid. so it is amortized across 5 years and interest expense will increase over and above the coupon. some might apply a straight line method = $71,326/5 = $14,265.2 equal payments every year.
take the reverse situation say the bond was issued at a premium at $1,071,000. at the end of the 5years the issuer will have to return ONLY $1,000,000 and will get to keep the $71,000. those $71,000 will have to be amortized across the 5 years which will reduce your interest expense.
The only interest rate that matters in amortizing a bond premium or discount is the YTM when the bonds were issued. It is that interest rate that you use in the effective interest rate method to amortize the premium or discount. What happens to interest rates (and the market price of the bonds) between issuance and redemption is of no concern to the issuer.
Hope you don’t mind if I piggy back on this question…so the interest expense is the the Carry * Mkt rate at time correct? On the income statment , is interest paid = the coupon payment or the interst expense (I’m guessing expense). On CFO , is it then the coupon that is getting paid (Actual cash leaving).
In the income statement, there is no such thing as “interest paid”. There’s “interest expense”, which is the (beginning) carrying amount times the YTM at issuance. Interest paid – the actual cash paid for interest – would show up explicitly on the cash flow statement if CFO is presented using the direct method, but will not show up explicitly if CFO is presented using the indirect method (all you’ll see is an adjustment to net income for the amortization of the bond premium or discount).
thanks Nicholas for the explanation…very clear and succinct!