>> Hello, I'm Professor Brian Bushee. Welcome back. In this video, we're going to continue our look at bonds. Looking at issues like discount bonds, premium bonds, retirement before maturity and how all of this affects the statement of cash flows. Let's get started. Okay. So let's talk about what we mean by discount and premium bonds. So in the example that we did last video, the KP bond. KP bond was assumed to be issued at par. Which means that its coupon rate, 5% equal the effective rate or the market rate when the bond was issued, which was also 5%. So issued at par, means coupon rate equals the market interest rate. The companies can issue bonds and often issue bonds that have coupon payments that are different amounts than what the market rate is. When the coupon rate is below the market rate, the bond is referred to a discount bond. So the price is going to be below face value. Investors are willing to pay less for the bond because the coupon rate is less than the current market rate. So if the coupon rate was 5% but the market rate is 6%, you're getting less interest from the bond. So you're going to pay less than the face value to get the bond. So if it's 10,000 bond, dollar bond, you'll pay less than 10,000. When the coupon rate is above the market rate, the bond is referred to as a premium bond. So here the price is going to be above face value. Investors are willing to pay more for the bond because the coupon rate is greater than the current market rate. So the coupon rate is 5%, the market rate is only 3%. So you're getting much more payment with the bond. So you're going to pay more than the $10,000 face value to get that 5% coupon rate instead of the market rate of 3%. >> Does this mean that I am getting a good deal if I am able to buy a bond at a discount? >> Or, are discount bonds something that are sold in a clearance aisle at Wal-Mart? >> I said, no more dumb bond jokes. >> Wow, [LAUGH] we're off to a good start. So, a discount bond does not mean that you're getting a deal. It's not in the clearance aisle. All a discount bond means is that the proceeds are below the face value. But that's the case because the market interest rate is above the coupon rate. And that lower proceeds simply reflects the correct price based on the time value of money. You're not getting a deal with a discount bond, you're playing exactly the right amount based on the time value of money assuming current market rates. So now, let's talk about interest expense. So in the prior video, we saw that interest expense equaled the coupon payment. But that's only going to be the case when the bonds are issued at par, when the proceeds from the bond equal the face value. So if you have a $10,000 face value bond, you receive $10,000 proceeds. What it means is that the coupon rate was the same as the market rate. And so interest expense equals cash, the coupon payment. [NOISE] But most of the time [LAUGH] when companies issue bonds, they're issued at a discount. Sometimes at a premium. And the interest expense has to be based on something called the effective interest rate. The effective interest rate is the market rate that was in effect at the time you issued it. So when you issue the bond, it was the interest rate that the investors were willing to pay you based on their present value calculations. That effective interest rates what we're going to use for accounting and it's not changed over the life of the bond. So even if market interest rates go up or down, we keep the same effective rate throughout the life of the bond. [SOUND] So the format that we're going to use for the interest expense journal entry is the following and this is an important one, so you want to make sure you get what this one down. Although [LAUGH] you're going to have plenty of practice as we go through the rest of the video. So we're going to debit interest expense, we're going to recognize interest expense on the income statement. The dollar amount is going to be equal to the balance and bonds payable to beginning of the period times the effective interest rate. So this interest rate that was in effect when the bond was issued. The credit to cash is going to be the coupon payment. So the face value on the bond times the coupon rate. And notice those are only going to be the same if the face value equals the balance in bonds payable and if the coupon rate equals the effective interest rate. And that's only going to be the case when the bond's issued at par. For all of these discounter premium bonds, they are going to be different and what we're going to need is a plug to bonds payable. So we're either going to debit or credit bonds payable if we issue a bond at a premium or discount, which will mean that this interest expense does not equal cash. So if interest expense does not equal cash, we're going to need a debit or a credit to bonds payable to make this thing balance. >> Let me get this straight. The cash interest payment made by the company is not the same as interest expense. We use the interest rate in effect when the bond was issued, even if it was issued a long time ago and the interest rate has changed. And we might have to debit or credit the notes payable principal amount, even when we are not paying any principal. This is most convoluted accounting I have ever seen! >> It is almost as convoluted as the plot for Tomorrow Never Dies. That was a bad bond video! >> Paul that was an excellent summary of everything that was on the slide. And I actually don't think it's as convoluted as the plot of Tomorrow Never Dies. I actually think it all makes sense and hopefully it will all make sense to you when we go through some examples. So lets take a look at how this journal entry works with some examples. So again, a bond issued at par would be the effective rate is the same as the coupon rate. So the coupon rate is what the bond is paying in cash every six months. That rate is exactly the same as what the market views the interest rate for the bond to be, so we get proceeds the present value of 10,000 equals the face value. So the interest expense is 250, that's the bonds payable balance the 10,000 of proceeds times the effective interest rate, 5%. But of coarse, it's divided by 2 since it's some annual to 2 and a half percent. [SOUND] We credit cash for 250, that's the $10,000 face value times the coupon rate. To get the coupon payment. Coupon rate is 5%. But again, we divide it by 2, 2 and a half percent. So we issued at par, interest expense equals cash. Now lets look at one that's issued at a discount. So here the effective rate or the market rate is 6%. The coupon rate is 5%. So, the coupon rate is paying investors less than the market interest rate and so what happens is the proceeds are lower than the face value. So that's why it's called the discount. So if you remember back in the present value, time value money videos. If the interest rate goes up, the present value goes down. So what happen here is the effective rate has gone above the coupon rate, so the present value goes down below the face value of 10,000. And you should move your hands up and down as you talk about it because I'm doing that here even though you can't see it. Anyway, we debit interest expense for 292 that's the proceeds of 9,729 times the effective rate 6%. Divided by 2 for half a year. [SOUND] We credit cash for 250. That's the coupon payment, which is the face value times the coupon rate, 5%, divided by 2. Notice what happened is, it's the same coupon rate and face value as the bond issued par. Which means the cash is not changing. What's changing is the interest expense. [SOUND] And then to make this balance, we need a plug to bonds payable. It's what we need to make the debits equal to credits. Now what this is going to do, this is foreshadowing what I'll show you in the example in a little bit. By crediting bonds payable, we're making that balance go up so the proceeds of 9,729 we would add 42 to that. And over time it will eventually grow to be 10,000. Which is what we owe at maturity. But you'll see that more when we go through a detailed example. [SOUND] Final example in this slide [LAUGH] is bond issued at a premium. [SOUND] So here the effective rate, the market rate is 4%, the coupon rate is 5%. So, the company's actually giving investors a better deal. They're giving them a higher rate on the coupon than they could get in the market, so the proceeds are greater than the face value. Investors are willing to pay more than $10,000 to get this higher interest rate. Or another way to think about it is. The market rate has gone down below the coupon rate, which means the present value goes up above the face value that inverse relationship. Journal entries debit interest expense for 206. That's the proceeds of 10,280 times the effective rate of 4%, of course divided by 2 to get 2%. Cash is 250, because the coupon rate and the face value are the same. So the cash payment is the same. And this time, our plug is a debit to bonds payable for 44 that debits going to reduce the balance and bonds payable. And over time, it's going to reduce the balance of bonds payable from 10 to 80 down to the face value of 10,000 which is what the company will pay at maturity. >> Whew, that make sense. Not. When is this video going to be over? >> This video's not going to be over for another 15 minutes of clock time. And maybe two or three hours of perceived time. So I know this is a dense slide. This is meant to be a summary that you could look back on to see how this works. We're going to go through some examples more slowly now. And hopefully, the mechanics of this will be clearer through those examples. So let's go through a detailed example of accounting for a discount bond. So January 1, 2010, KP is going to its three year, 5%, $10,000 face value bond. But now, investors are pricing the bond using an effective or market interest rate of 6%. Because the market rate is 6%, but we're only paying 5%. The market's not going to give us $10,000. They're going to give us less than that. A discount 9,729. So the market rate is higher than the coupon, the proceeds are lower than the face value. Inverse relationship. To calculate the bond price, what you could do is use Excel or your calculator or the tables. Plugin a face value or future value of 10,000, a rate of 3%. Which of course is half of the annual rate of 6%. That's the effective rate. Number of periods is six, three years. [SOUND] Payment which is based on the coupon rate. So that's 5% divided by 2. That's 2 and a half percent times 10,000. And you'd come up with a present value 9,729. Now I'm not going to show you that in Excel, I'll leave that up for you to do on your own. [SOUND] But what I want to get to now is what is the journal entry that KP would make when they issue this bond? Let me go ahead and throw up the pause sign and you can try and think about what it would be. [SOUND] Okay. So we're going to debit cash for 9,729 because we're receiving cash for the proceeds, the present value. [SOUND] And we credit bonds payable, the liability for 9,729. So notice, we create a liability that's less than the face value. Even though we're going to to have to pay the face value of 10,000 at maturity. No problem, as you'll see. Eventually, we'll grow that bond's payable so that at maturity it's equal to $10,000, which is what we owe at that point. [SOUND] So to see how this all plays out, it's handy to do one of these amortization schedules again. So when we get to our first coupon payment on June 30th, we have a beginning balance in bonds payable of 9,729. The interest expense is going to be that beginning balance of 9,729 times the effective rate of 3%, so that gives us interest expense of 292. The coupon payment, the cash payment is equal to the face value of 10,000 times the coupon rate, 5% divided by 2. 2 and a half percent to get $250 cash paid. So if you can picture the journal entry in your mind, we're debiting interest expense, crediting cash paid. It doesn't balance, so we need a plug to bond payable of 42. That's the difference between the interest expense and the cash paid. That 42 is going to get added to 9,729 to come up with an ending balance of 9,771. [SOUND] Then you would do that for every six months to maturity. So a couple things to notice here. The cash paid never changes, so the coupon payment is the same every six months. Interest expense though gets bigger every six months, because it's based on the balance and bonds payable. And the bonds payable balance is growing over time. The balance and bonds payable is growing over time because our plug to bonds payable gets bigger over time. And if you notice at maturity, the balance and bonds payable is $10,000 which is exactly what we owe at that point. So the accounting [LAUGH] all works out in the end. [SOUND] So, let's practice doing one of these effective interest method journal entries. So I'll put up the pause sign and try to do the journal entry for June 30, 2010, which is the bolded row in the schedule Okay. So we debit interest expense for 292. That's the bonds payable balance times the effective rate of 3%. We credit cash for 250. That's the coupon payment, 10,000 times 2 and a half percent. And we plug bonds payable to make the debits equal to credits. So that's a credit of 42, which increases the ending balance. And then makes the interest expense higher the next period. [SOUND] So now, I want you to try the journal entry for the last period. 12, 31, 2012. And I'll put up the pause sign and you can give that journal entry a shot. Okay. So we're going to debit interest expense for 299, which is that last interest expense in the column. We'll also have to pay back the bonds payable balance, so we debit bonds payable for 10,000 so that we can zero that out. We're going to credit cash for 10,250 and we also have the credit to bonds payable at 49, which was the plug. And obviously, you could combine that debit and credit to bonds payable into one entry. I split it apart so it would be easier to see where those two numbers come from. >> I remember hearing about something called a zero-coupon bond. Is that related to what we're doing here? >> I bet Timothy Dalton played James Bond in the zero-coupon bond video. >> Yes, a zero-coupon bond is an extreme example of a discount bond. I know I'm taxing your patience enough already, so I'm not going to go through it in detail. But let me just quickly give you and overview of how it works. So in a zero-coupon bond, you would borrow, say, $9,000 and then just pay it back $10,000 at maturity without making any coupons, coupon payments in the interim. So what it's going to look like on an amortization schedule is, there's going to be no cash payments as you go through the bond. So this interest expense will just be equal to the increase in bonds payable. And eventually, will increase the bonds payable up from $9,000 originally to $10,000, which is the cash payment that you make at maturity. So it works just the same, except that there's no cash payments every six months. There's just the repayment of what you owe at maturity. So if that wasn't complicated enough, there's a little bit of a wrinkle with discount bonds and the statement of cash flows. When we have bonds issued at a discount, part of the interest expense is noncash. The noncash amount is equal to that plug to bonds payable. So remember the journal entry we did. We debited interest expense for 292. [SOUND] We credited cash for 250 and so we credited bonds payable for the plug of 42. That plug of 42 represents the noncash portion of interest expense. So again, if you think of how the statement of cash flow works, interest expense is part of net income. But we need to adjust that to get to cash. So we have to pull out the noncash part of interest expense, the 42 to get from interest expense to cash. We do that by adding back that 42 in the operating section of this statement of cash flows under the indirect method. This is often labeled something like amortization of bond discount. Now I know we usually use amortization for intangible assets, whereas this is a liability but it's tradition. You don't want to mess with tradition. So this is typically called an Amortization of Bond Discount. The key thing is we've got this noncash interest expense that we need to remove on the statement of cash flows under the indirect method. >> So, if you're keeping score at home, that means we have to add back depreciation and amortization, losses on sales on investments and amortization of bond discount in the operating section of the SCF. Phew, that is a lot to remember. >> Another excellent summary, Paul. Good job. So a quicker way to remember this is any noncash items have to be taken out in the indirect method for SCF. And then any gains or loses related to investing activities or financing activities have to be taken out, as well. And it's nice to have a simple rule like that, because I'm going to keep adding to the list. So I also have an example of accounting for a premium bond. But to be honest with you, very few bonds are ever issued at a premium. The vast, vast, vast majority of bonds are either at a discount or at par. I don't know, there's probably some investor psychology reason behind this. So this is not something that's really important for the real world. I'm going to go through it quickly for completeness to get another review of the mechanics. If you want to go through it more slowly, then I guess just watch it again at half speed. So KP issues the same bond. Three year, 5% coupon, $10,000 face value. But now the market rate is 4%, so the market rate has dropped below the coupon. Which means investors are willing to pay a premium. Proceeds are above face value. [SOUND] You could figure that out through present value calculations. So if you in all the perimeters, what's really changed here is the interest rate is now 2% instead of 3% in the discount example. [SOUND] You would end up with a present value of 10,280. And I noticed I missed the n equals 6. So go ahead and write that in, but, but not on your computer screen. But maybe on the printout for the slides. [SOUND] Anyway, the journal entry on issuance would be debit cash, 10.280 and credit bonds payable 10,280. [SOUND] This is what the amortization schedule is going to look like. First thing to notice is the interest expense is always less than the cash paid, that's because the effective rate of 4% is below the coupon rate of 5%. Of course, the coupon rate, coupon payment is the same every period. And so we're have is our plug to bonds payable is always going to be a debit, it's always going to reduce bonds payable. So over the life of the bond, bonds payable balance gets reduced from 1080 down to 10,000, which is what we owe at maturity. So to do a interest expense entry, you would debit interest expense for 206, taking the June 30, 2010. Credit cash for 250 and then a plug as a debit to the bonds payable. [SOUND] And then at maturity, again debit interest expense, credit cash and then debit bonds payable for the 10,000 plus the last debit for the interest payment of 49. So, it's almost the mere image of the discount. In fact, you could hold the video up to a mirror. And you would see that the premium is the mirror image [LAUGH] of the discount. So let's move on to the next topic. Retirement before maturity. Now, now I'm not talking about my career. I'm talking about retiring a bond before the bond matures. [SOUND] So sometimes firms decide to retire a bond if they have excess cash or they want to refinance their debt. And so what they have to do is buy the bonds back from investors at current market prices. So investors are holding these bonds. The firm has to offer them cash based on current interest rates to get the bonds back. The price the firm pays to buy back the bonds are typically different from the book value. And that's going to be the case, because the book value's based on the original interest rate. If the interest rate has moved up or down since then, then the current value will be different from the book value. [SOUND] Gain or loss is going to be recorded on the income statement for the difference between the book value of the bonds and the price we have to buy them back. This gain or loss is going to be backed out of the operating section of this statement of cash flows under the indirect method because it's a financing activity. It's going to look just like the gain or loss on sale of property client and equipment. So we have to remove this from the statement of cash flows. >> Here is another thing. To add back in the operating section of the SCF. But, my question is, why can't the company just pay back the principal to retire the bond? >> Yeah, it seems logical [LAUGH] that if you have a $10,000 bond, why not just give the investors $10,000 and be done with it? Well, that's the wrong amount. Because first of all, that $10,000 is how much you owe at maturity at some point in the future. As we've been talking about with time value of money, that 10,000 in future dollars is not worth necessarily, $10,000 today. In fact, it won't be worth $10,000 today if there's any kind of positive interest rate. So investors want what it's worth in today's dollars. Plus, if you're retiring it before maturity, investors are losing those coupon payments that they originally paid for when they bought the bond. And so they have to be made whole for the loss of those coupon payments. So our need to do a present value calculation to figure out exactly how much they'd have to pay to retire the bonds. So let's look at some examples of how this retirement before maturity works. So first, we're going to look at the situation where you end up booking a loss. On July 1, 2011, KP decided to buy back it's bonds, which were issued an effective interest rate of 6%, so we're looking at the discount scenario. The market rate has dropped to 4% on this date, so KP must pay $10,144 to retire the bond. Now I'm not not going to go through that calculation but I'll put a challenge out there. So see if you can figure out that calculation and if you figure it out, post to the discussion forum for this video. The first person to post the correct methodology for getting this will win a prize. The prize is I'll post good job under your answer. Anyway, [SOUND] what we have to do is go back to the amortization schedule and see where we are for the balance in bonds payable. So as of July 1, 2011, the balance is 9,858 because we've had three entries so far where we've, where we've increased the bonds payable balance through that plug. [SOUND] So I'm going to put up the pause sign and see if you can record the journal entry for paying the cash to retire this bond. So we want to debit bonds payable for 9858, so we want to zero out that balance and bonds payable, because we're retiring it. We want to credit cash for 10,144, which is the cash that we're paying investors to buy back the bonds. We need a plug, the plug is loss on retirement which will go on the income statement. Now, next, let's look at a gain scenario. So the same bond, same discount, effective interest rate of 6%. Now when we want to buy it back on July 1st, the market rate has climbed at 8%, so KP has to pay 95 584 to retire the bond. Same challenge. See if you can figure out where I got that number and post it to the discussion forum. So, bringing back up our amortization schedule it's the same as before, up until July 1st, we've been amp, we've been working on the bond. Plug in bonds payable. The balance is 9,858. So on July 1, 2011, what is the entry that would be made to retire this bond? Okay. So we're going to debit bonds payable for 9,858, so that's the same thing. We need to zero out that balance because we're retiring it. We pay cash 9,584 because that's what the market demands to retire the bond. And here we credit a gain on retirement to make it balance, so that gain is going to go on the income statement, gain on the retirement or bond. >> Wait. It looks like the company got a gain because interest rates went up. Isn't an increase in interest rates bad news? Isn't a gain good news? This is almost as confusing as the plot from Quantum of Solace. >> Yeah. So when you retire a bond before maturity, you're essentially marking it to market. You're marking it to fair value. And anytime you mark liabilities to fair value, you enter this bizarro world of accounting, where in an increase in interest rates is bad news. But it shows up as a gain. A decline in interest rates is good news, that's what we saw earlier, but it shows up as a loss. So you can't view gains and losses on these fair value of liabilities or these retirements before maturity as good news or bad news, because they don't have that same interpretation. And what's even crazier is some companies voluntarily carry their long term debt on a fair value basis and so they have these bizarre gains and losses all the time, as I'll show you in the next slide. [SOUND] Okay. One more topic, one more slide and we'll wrap this up. So under both U.S. GAAP and IFRS, companies have the option to measure long-term debt at fair value, the market value, rather than at amortized cost using historical market rates. So basically, all that accounting that we've been looking at so far. You don't have to do that if you choose to do this fair value option. You might do that because under amortized cost, the book value of long-term debt on your balance sheet can deviate substantially from what the current fair value is. And what happens is if you then decide to retire your bonds, all of that gain or loss hits the income statement immediately. But what would happen under the fair value option is you would recognize those unrealized gains and losses every quarter, because you'd adjust the book value of long-term debt to reflect the current market value. [SOUND] So if the market value of your debt went up, you would book an unrealized loss and a credit to bonds payable. Credit to bonds payable increases the balance to the current market value. We offset that with a debit on realized loss and if there's a decrease in market value, you have to reduce your bonds payable account. Debit bonds payable and credit an unrealized gain. Now what happens is financial services firms, like banks are the only ones that tend to do this in any large numbers. And that's because they're hedging other kinds of fair value explosion. The balance sheets of these unrealized gains or losses may cancel other unrealized gains and losses elsewhere, as everything's marked to market value. Non-financial firms, so firms that are not banks almost never elect this. Because they don't want their net income to be volatile based on changes in the value of their bonds, if they just intend to hold them and then pay them off at maturity. Any questions on this? Yeah. After two mammoth videos on bonds, I could use a nap myself. [LAUGH] So let's all rest up and I'll see you next time when we talk about leases. See you then. >> See you next video.