Hey guys, Can anyone shed some light on the way interest expense is ‘recognized’ between a premium/discount bond on all the financial statements? Can you knowledgeable accounting guys confirm the below? Coupon payment- Subtracted out of CFO from Cash flow statement as ‘Interest Expense’ Interest expense- Recorded in Income Statement Remaining Liabilities- Recorded in Balance SheetPV of remaining balance(principal + interest at issuance) Proceeds from bond- Recorded in CFF in Cash Flow statement Proceedes from repayment of Face Value- Recorded in CFF in Cash Flow statement That being said, i’m confused on how CFO is ‘overstated’ and CFF is ‘understated’, bc the books aren’t clear. For a Premium bond, Coupon(lets say 5000)>interest expense(4100) on income statement. Is CFO understated? Why is CFF Overstated? For a Discount bond, Coupon(lets say 5000) < interest expense (5700) on income statement. Why is CFO overstated, and why is CFF understated? Thanks a lot guys,
In the case of a bond issued at discount, the discount is actually booked by the issuer as a loss (the issuer receives a smaller amount than it has to pay to the investor at maturity) that is recognized through amortization along the life of the bond by increasing the Interest Expense (IE). You will have an IE higher than the cash coupon payment. I will use an example from Stalla: Say: - The face value of the bond is $1,000 but (FV=1000) - it has been issued at a discount price of $930 (PV=930) – the Book Value. The difference between the face value and the book value is a loss that will be amortized until maturity, - has a coupon of 6% (that is a 3% period payment = PMT = $30) and - 4 years to maturity (N=8 – coupon payments semiannually). If you input the above into a calculator, you’ll get the period I/Y=4.0415%, which is the period market interest rate at issuance. Semiannually, the issuer of the bond would have to ACTUALLY pay the investor the fixed coupon payment of $30, but the interest expense is in fact IE = I/Y*Book Value = 4.0415%*$930, that is $37.59. See the difference between the coupon payment and the interest expense? Well, the $7.59, a small piece of the loss of $70 is the amortization of the loss, added back to the book value => carrying value of the bond (CV), used for calculation of the interest expense for the next period. Further, as the Carrying Value increases with each payment of coupon (increases with the difference between the interest expense and coupon payment), so does the interest expense (IE in period 2 = I/Y*CV in period 1, CV period 1 = Book Value + IE in period 1 - Coupon). The IE (what you record) will always be > ACTUAL cash flow (the coupon) so the CFO is higher than it would have been otherwise => higher net CFO, CFO is overstated. For a bond issued at discount: - understatement of CFF (with the difference between the face value and the price), the difference being a loss amortized during bond’s life - overstatement of CFO (higher IE than actual CFO outflow) - at maturity, the Carrying Value would be equal to the face value, and the entire loss would be amortized For a bond issued at a premium, the above work in exactly the opposite way: - overstatement of CFF (with the difference between the face value and the price), the difference being a gain - understatement of CFO (lower IE than actual CFO outflow)
map, thanks for the clarification. i think you cleared up the CFF overstatement/understatement part, which i believe you are saying is the loss from the proceeds of a discount being less than the face value (ex. $930 proceeds recorded on CFF vs. the 1000 face value that ‘should’ have been recorded). therefore, you are saying CFF is undervalued on a discount bond. is this correct?
I am saying that CFF is understated because the company receives $930 and has to pay back $1000. Coupon payment: Cash Flow Statement, CFO outflow Interest Expense is on your Income Statement Proceeds from the bond issue: Cash Flow Statement, CFF inflow Repayment of the bond at maturity: Cash Flow Statement, CFF outflow Now for the remaining liabilities (which I suppose you are referring as being the difference between par value – of $1000 and price of $930): get them on your balance sheet, together with your assets At the time of bond issue: A= L+E Assets are going up (cash is going up $930) Bonds payable are going up (liability of $1000) Bond Discount (a liability contra account- the loss of $70 representing unamortized discount, loss not yet discarded) During the life of the bond: A = L + E As the bond discount is amortized (the bond discount decreases with the difference between the interest expense and coupon – L is going down), the value of your assets increases (with the value – building up the carrying value – A is going up). In the end, at maturity, your asset with its Carrying Value would reach $1000. At bond repayment, A goes down with the carrying value of $1000 (cash out), Liability goes down with $1000, the Bond Discount (part of your Liability) has been already amortized completely.
I think it in this way: For premium bond, coupon payment is comprised of two parts, principal repayment and interest expense. CFO is undersated because it takes the total coupon payment as operating cash outflow, while only interest expense should be counted. The principal part should have been recorded as CFF outflow, but actually it is not recorded as such, so CFF is overstated. It’s just the opposite story for discount bond.
i think the key thing to understand is “A Discount Bond, CFF is Understated with respect to What?” It is understated with respect to CFF of a Par Bond. So then think about it. Par bond - CFF = 1000 (Cash In). Discount Bond = 900 (Cash In). So Understated. “A Premium Bond, CFF is Overstated with respect to What?” It is overstated with respect to CFF of a Par Bond. So then think about it. Par bond - CFF = 1000 (Cash In). Discount Bond = 1100 (Cash In). So Overstated.
Quick question: If a bond is issued at a discount, the actual money paid to the issuer when issued is still the face value of the bond. Correct? But, if the market interest rate is higher than the coupon rate, then the face value is recorded (in both the balance sheet and cash flows) at the present value using the market interest rate. Is this correct?
So for a Bond issued at discount you have the following T-Account DR Cash------------ 930 DR Bond Discount-- 70 ----CR Bond Payable------ 1000
How much cash does the person buying the bond pay to issuer? $930? or $1000? I’m confused as to whether that $930 is the actual money paid or whether it’s recorded at that because it’s the PV of the par value is $930.
Buyer pays $930, receives $30 in coupon payment per period and $1000 at maturity. Issuer receives $930, pays $30 in coupon payment per period and $1000 at maturity.
. wrong post. Look at map1’s explanation
BS records: A - $930 L - $1000, the face value L - ($70) the undiscounted coupon, a liability counter account - Bond Discount E - no change As payment goes on, at each payment: increase assets with the difference between the coupon payment and the interest expense, you begin recovering/amortizing the undiscounted coupon: A - goes up with the difference between the coupon payment and the interest expense, L-$1000 L- Bond discount goes down with the same amount A goes up