only 2.5 weeks till the exam and I still don’t get this…please help… i’ve been trying to figure this out for a while now this is in book 3, under long term liabilities and leases So when you issue a bond, you receive $$ and you have to make periodic coupon payments. but why is there interest expense when you’re already making coupon payments? why is beginning book value + interest expense - coupon = ending book value ? so confused @_@… any help is appreciated. THANKS!!
I take it that you believe the whole amount should be interest because principal will be paid at maturity. Let me know if that is not what you are saying. The bond gets issued at a premium or discount and that is going to be the carrying amount on the b/s. The payments made on that bond are going to consist of 2 parts - interest and amortization. The interest part is the coupon rate times the beginning balance. The amortization is going to be the payment amount minus the interest expense. I don’t know if that helps, but it’s how I think of it.
But aside from amortizing discount or premium (which are real issues, for sure), there is still the issue of accrued interest. Remember that accounting is about recognizing accruals not just cash flows. If you have a bond that pays coupons every 6 months and you pay a coupon in October but prepare financial statements in December, you have two months worth of accrued interest expense.
Perhaps another way to look at it would be as follows: 1. when a bond is issued at a discount (premium), the actual interest rate paid by the borrower is higher (lower) than the coupon. the true cost of borrowing is the YTM at time of debt issuance (ignoring call / put provisions of course). the coupon rate is not the actual borrowing cost (except for an option-free par bond) 2. interest expense (accounting accrual) is different from coupon payment (cash flow) as pointed out above by Joey. why is beginning book value + interest expense - coupon = ending book value ? think in terms of accruals. the borrower records liability = “beginning book value” at t0. during the year interest expense is accrued (accounting accrual) using YTM (not coupon rate) as the interest rate on beginning balance. the book liability becomes “beginning book value” + interest expense then coupon interest is paid (cash flow) against the liability. now the book value of liability becomes “beginning book value” + interest expense - coupon payment
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