�OVERVIEW OF BONDS�COLUMBIA CORE ACCOUNTING�REVIEW SESSION��ANTHONY LE�

WHAT ARE BONDS?

• You can think of “bonds" as a way for a company to raise funds: they “issue" (or sell) bonds to the public in exchange for cash (think of it like a loan) �
• Bonds pay a fixed amount of interest, which we call “coupon payments". You can think of coupon payments as an extra amount of interest that the company will pay to the bondholder.�
• At the bond’s “maturity" date, the issuer (i.e. the company) pays back the principal to the bondholder (i.e. the bondholder/investor)

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WHAT ARE BONDS?

Company A

Person B

(Bondholder)

(1) “Issue” a Bond

YEAR: 2018

BOND TERMS

Term to Maturity: 3 Years

Coupon Rate: 5%

Face Value: $1000

Price of the Bond: $900

+ $900 Cash

WHAT ARE BONDS?

Company A

YEAR: 2018

BOND TERMS

Term to Maturity: 3 Years

Coupon Rate: 5%

Face Value: $1000

Price of the Bond: $900

Company A’s Accounting Journal Entry:

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Dr Bond Discount 100

Dr Cash 900

Cr Bonds Payable 1000

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Why $900 in Cash? That’s what Company A received for

the bond (i.e., they raised $900 in cash).

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Why $1000 for Bonds Payable? The “face value” of the

bond is $1000, meaning the company has an obligation

to pay the bondholder $1000 at maturity.

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Why $100 for Bond Discount? The discount of the bond

is always the difference between what the person paid (900)

and the obligation the company has to pay (1000). Since

they received less than their obgliation, we say the bond was

sold at a “discount.”

WHAT ARE BONDS?

Company A

Person B

(Bondholder)

(1) Pay a “coupon” payment

YEAR: 2019

BOND TERMS

Term to Maturity: 3 Years

Coupon Rate: 5%

Face Value: $1000

Price of the Bond: $900

- (0.05*1000) = - $50 Cash

WHAT ARE BONDS?

Company A

Person B

(Bondholder)

(1) Pay a “coupon” payment

YEAR: 2020

BOND TERMS

Term to Maturity: 3 Years

Coupon Rate: 5%

Face Value: $1000

Price of the Bond: $900

- $50 Cash

WHAT ARE BONDS?

Company A

Person B

(Bondholder)

• Pay a “coupon” payment
• Pay back “face value”

YEAR: 2021

BOND TERMS

Term to Maturity: 3 Years

Coupon Rate: 5%

Face Value: $1000

Price of the Bond: $900

- $50 Cash

- $1,000 Cash

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

Year 0

Year 1

Year 2

Year 3

Year 4

NOTE: The “price of the bond” will be equal to the present value

of the stream of cash flows that the bond pays out to the

bondholder.

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.07 * 1000 = $70

(2) -$1,000

(repayment of the “face value”)

(1) -$70�(coupon payment 4)

(1) -$70�(coupon payment 3)

(1) -$70�(coupon payment 2)

(1) -$70�(coupon payment 1)

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

Problem: Not as simple as “adding up all of the cash flows” because of the time value of money: $70 today is not the same as $70 one year from now or $70 two years from now.

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So, the price of the bond is not equal to 70 + 70 + 70 + 70 + 1000��Solution: We will “discount” all of the cash flows to express this in “present value” terms (i.e., in terms of Year 0 dollars)

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Assume a company XYZ Ltd has issued a bond having a face value of

$1000, carrying an annual coupon rate of 7% and maturing in 4

years. The prevailing market rate of interest (also known as the “annual yield”) is 9%.

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Putting everything together …

JOURNAL ENTRIES FOR BONDS

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $935.20

Year 0 (Bond Issuance)

Dr Bond Discount 64.80

Dr Cash 935.20

Cr Bonds Payable 1000

Year 1 (First Coupon Payment)

Dr Interest Expense (Annual Yield * Carrying Value) 84.17

Cr Cash (Coupon Payment) 70

Cr Bond Discount (Interest Expense – Cash) 14.17

Interest Expense = Annual Yield * “Carrying Value of Bond”

= 0.09 * (Face Value – Bond Discount)

= 0.09 * (1000 – 64.80)

= 0.09 * (935.20)

= $84.17

Conceptual point: why are bonds issued at a discount? Because the coupon payment (i.e., the interest payments) the company decided to pay at 7% is less than the market interest rate of 9%. So they can’t sell it at $1,000 because otherwise the bondholder would rather invest their money in the market and earn a higher interest rate.

JOURNAL ENTRIES FOR BONDS

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $935.20

Year 2 (Second Coupon Payment)

Dr Interest Expense (Annual Yield * Carrying Value) 85.44

Cr Cash (Coupon Payment) 70

Cr Bond Discount (Interest Expense – Cash) 15.44

Interest Expense = Annual Yield * “Carrying Value of Bond”

= 0.09 * (Face Value – Bond Discount)� = 0.09 * (1000 – (64.80 - 14.17))

= 0.09 * (1000 – 50.63)

= 0.09 * (949.37)

= $85.44

Year 3 (Third Coupon Payment)

Dr Interest Expense (Annual Yield * Carrying Value) 86.83

Cr Cash (Coupon Payment) 70

Cr Bond Discount (Interest Expense – Cash) 16.83

Interest Expense = Annual Yield * “Carrying Value of Bond”

= 0.09 * (Face Value – Bond Discount)� = 0.09 * (1000 – (64.80 - 14.17 - 15.44))

= 0.09 * (1000 – 35.19)

= 0.09 * (964.81)

= $86.83

JOURNAL ENTRIES FOR BONDS

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $935.20

Year 4 (Fourth and Last Coupon Payment)

Dr Interest Expense (Annual Yield * Carrying Value) 88.36

Cr Cash (Coupon Payment) 70

Cr Bond Discount (Interest Expense – Cash) 18.36

Interest Expense = Annual Yield * “Carrying Value of Bond”

= 0.09 * (Face Value – Bond Discount)� = 0.09 * (1000 – (64.80 - 14.17 - 15.44 - 16.83))

= 0.09 * (1000 – 18.36)

= 0.09 * (981.64)

= $88.36

Year 4 (Bond Retirement/Bond Maturity)

Dr Bonds Payable 1000

Cr Cash 1000

BOND ACCOUNTS OVER THE YEARS

Year 0

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Year 1

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Year 2

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Year 3

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Year 4

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End (Total)

Cash Bonds Payable Bond Discount (Contra Liability) Retained Earnings (Interest Expense)

+935.20

Assets Liabilities Equity

+1000

-64.80

-70

+14.17

-84.17

+15.44

+16.83

+18.36

-85.44

-86.83

-88.63

$0

-70

-70

-1070

-1000

$0

-344.8

-344.8

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity (total): 4 Years

Coupon Rate: 6%

Face Value: $1000

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Year 0

Year 1

Year 2

Year 3

Year 4

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

(2) -$1,000

(repayment of the “face value”)

(1) -$60�(coupon payment 4)

(1) -$60�(coupon payment 3)

(1) -$60�(coupon payment 2)

(1) -$60�(coupon payment 1)

January 2, 2019

December 31, 2019

December 31, 2020

December 31, 2021

December 31, 2022

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity (total): 4 Years

Coupon Rate: 6%

Face Value: $1000

Annual Yield (on Jan 2, 2021): 10%

Price of the Bond: $?

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Year 0

Year 1

Year 2

Year 3

Year 4

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

(2) -$1,000

(repayment of the “face value”)

(1) -$60�(coupon payment 4)

(1) -$60�(coupon payment 3)

(1) -$60�(coupon payment 2)

(1) -$60�(coupon payment 1)

January 2, 2019

December 31, 2019

December 31, 2020

December 31, 2021

December 31, 2022

Where (in time) “Tenenhouse Financial Corporation” is standing when they repurchase the bond (right after the second coupon payment)

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To calculate the price of the bond: we will have to think about how much remaining cash flows (i.e., coupon payments 3 and 4 and repayment of face value) is worth

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity (total): 4 Years

Coupon Rate: 6%

Face Value: $1000

Annual Yield (on Jan 2, 2021): 10%

Price of the Bond: $?

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

1 Year

2 Years

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity (total): 4 Years

Coupon Rate: 6%

Face Value: $1000

Annual Yield (on Jan 2, 2021): 10%

Price of the Bond: $?

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

1 Year

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity (total): 4 Years

Coupon Rate: 6%

Face Value: $1000

Annual Yield (on Jan 2, 2021): 10%

Price of the Bond: $?

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

2 Years

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Putting everything together …

Journal Entry (Bond Repurchase and Retirement on January 2, 2021 – Part A of Problem Set 8 Question 1):�

Dr Bonds Payable 1000

Cr Cash 930.58

Cr Gain on Bond Retirement 69.42

Journal Entry (initial one in January 2, 2019 – not asked in Q1 of Problem Set 8):�

Dr Cash 1000

Cr Bonds Payable 1000

CALCULATING THE “PRICE OF A BOND”

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

Putting everything together …

Accounting Equation

Bonds Payable (Liability) - 1000

Cash (Asset) - 930.58

Retained Earnings (Gain on Bond Retirement) (Equity) +69.42

PROBLEM SET 8 QUESTION 1

BOND TERMS

Term to Maturity: 4 Years

Coupon Rate: 7%

Face Value: $1000

Annual Yield: 9%

Price of the Bond: $?

On January 2, 2019, the Tenenhouse Financial Corporation sold a large issue of Series A $1,000 denomination bonds. The bonds had a stated coupon rate of 6% (annual), had a term to maturity of four years, and made annual coupon payments (on December 31). Market conditions at the time were such that the bonds were sold at their face value. During the ensuing two years, market interest rates fluctuated widely, and by January 2, 2021, the Tenenhouse bonds were trading at a price that provided an annual yield of 10%. Tenenhouse’s management was considering purchasing the Series A bonds in the open market and retiring them. Record the purchase and retirement of one Series A bond on January 2, 2021.

Coupon Payment = Coupon Rate * Face Value

Coupon Payment = 0.06 * 1000 = $60

Excel Formula:

PV function on Excel

Rate = market interest rate/annual yield (10%)

Nper = number of periods (2 years)

Pmt = annual (coupon) payment (0.06*1000 = 60)

Fv = face value ($1000)

APPENDIX: DEFINITIONS

• Bonds: A form of debt that is sold to an investor/bondholder.�
• Issuance of Bond: The issuance of a bond refers to sale of a bond to a bondholder.�
• Face Value/Denomination/Principal Amount/Par Value: The face value of a bond is the amount that the company agrees to pay back the bond holder at maturity. This is similar to the “principal” of a loan: it is the amount (separate from any interest payments) that is agreed to be paid back to the lender.�
• Term to Maturity: The term of the bond refers to the number of years (or periods) that the bond is held until the company has to pay back the “face value” to the bondholder.�
• Coupon Rate: The rate at which the company pays out coupons. Coupons are similar to “interest” in a loan – these are regular (annual) payments that the company makes to the bondholder.�
• Annual Yield/Yield to Maturity/Market Interest Rate: The market interest rate (or the annual yield) is the prevailing interest rate in the market.�
• Price of a Bond: The present value of the stream of cash flows that the company pays out.

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• Sold “at par”: means to sell the bond at its face value. This is the case when the Price of the Bond = Face Value, or when the Coupon Rate = Market Interest Rate.

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