Accounting: Accounting for Bonds, James Bonds

People love in their labs you know to make self

driving tractors so that it never suffers Another Teamstersstrike at

still scarred from that your company decides that now five

hundred million dollars in debt would do nicely so that

it can actually do well of these things and have

some cushion in case business doesn't continue to be oh

so awesome The question you are given then revolves around

how you account for the issuance payment interest and then

retirement of these bonds So let's take each of these

items one by one and we'll add details about bonds

you've issued as we go along Well first on the

day that you actually issue the bonds to bond investors

I sell them bonds You will have to put it

double entry on your balance sheet to account for this

blessed event like you're giving out pieces of paper and

collecting five hundred million dollars in cash on that day

your cash account will go up by the five hundred

million bucks you just raised and your long term liability

account will also go up by five hundred million dollars

Okay big fat hairy detail here So note carefully Yeah

because we're just throwing these curve balls at you to

see if you really get this difficult set of concepts

Here we go So the bonds cost four percent in

interest That's your rent on the money and must be

paid down to zero dollars in seven years But with

no principal paydown required in year one or two in

year three of the company must begin paydown of twenty

five million dollars per quarter or one hundred million dollars

per year each year for five years until the bonds

are totally paid off Could the company two plus years

later issue more bonds to pay off the previous bonds

Oh you bet California Illinois and other blue states have

relied on this continued bond issuance to stave off bankruptcy

for decades So why not in corporate America to write

Well anyway here is what the payments will look like

over the next seven years So a year passes and

on the annual income statement you show a line expense

labeled bond interest and you would put in their twenty

million dollars Why twenty Well you borrowed five hundred million

dollars at four percent annual interest to incur total interest

for the year of twenty million dollars which you likely

pay off twice a year The way normal bond interest

is paid a ten million bucks so that twenty million

dollars was your cost of renting the five hundred million

dollars for that year No principles a down member in

your one and or two Did anything else change No

but a few things were about to note that the

bond principle was placed as a long term liability on

the balance sheet The definition of long term means do

in a year or longer Note also that after this

first year passes well the first principle stay down requirements

of the bond will continue on to be within one

year So as we get into the first quarter of

the second year after having rented that five hundred million

box each corridor another twenty five million will shift from

the balance sheet on the long term liability ass IG

nation to become a short term liability right because it'll

go from being a do a year or more to

being Teo within a year said another way Eighteen months

after having borrowed the five hundred million dollars a balance

sheet will show long term liability of four hundred fifty

million and short term liability of fifty million Okay so

let's roll the clock forward five years after you borrowed

the money The principal paydown requirement began after two years

and you've spent three years paying down a hundred million

bucks each year As per the bond requirement you now

owe two hundred million dollars for one hundred million dollars

being a short term liability hundred million dollars being a

long term liability So the offset on the declining numbers

in the liability sections of the bank NJ would have

come from your cash account declining as you sent out

cash in chunks of twenty five million dollars for principle

plus whatever interest was owed for the money being paid

off And note that as you pay the principal down

you owe less rent on it or less interest So

let's note that in the given quarter in which you

owed two hundred million dollars remaining on your bond thing

You're annualized Interest at this point would only be eight

million dollars because your principal has gone from five hundred

million dollars at which point you were paying twenty million

dollars a year to now Just going two hundred million

dollars and four percent of two hundred million is eight

million bucks Well as you continue paying down the principle

you're essentially renting fewer square feet of debt So your

rent on that debt goes down As any New Yorker

will too tell you that's even better than having rent

control So here is another big fat curveball to drive

you crazy or humble you If you think you really

understand bond accounting at this point I suppose your debt

is publicly traded Its value fluctuates daily such that the

marketplace at times values the five hundred million you borrowed

at five hundred twenty million IEA prizes your debt essentially

giving that debt a lower interest rate Because odds are

good you pay it off by it out early or

something like that and at other times the debt trades

cheap But only four hundred seventy five million dollars such

that someone buying into that four percent interest rate debt

is getting mohr than four percent interest from it right

The company still pays the twenty million dollars a year

to rent that money whether it's five twenty or four

seventy five because four percent was pegged on that five

hundred million dollars you issue right Twenty million dollars no

matter what does the daily trading valuation matter to you

Is an accountant Short answer No But what would happen

if your company was doing reasonably well And for whatever

reason the Fed decided to suddenly raise interest rates dramatically

at the same time crashing the price of your bonds

Well could you Is a company go into the market

and then buy back your own bonds Well you could

It's like buying back your own stock Totally fine Teo

Buy back your own dead as well If the bonds

which were at par of a thousand dollars a unit

suddenly cratered to trade for only six hundred dollars a

unit While you could in theory go into the market

after filing all kinds of legal disclaimers and waivers and

explanations Toe Wall Street about why you're doing this and

what your doings of the entire world knew every little

detail Then you could offer or tender for your own

bonds at saying sixty five cents on the dollar Maybe

having just sold them eighteen months earlier for a hundred

cents on the dollar Well how would you account for

this Well you would add a new line on the

expenses line of your income statement showing an expense of

retirement of outstanding debt You would then look to your

balance sheet where cash one out the door of saving

three hundred fifty million that is your cash account would

decline by three hundred fifty million dollars But then here

short and long term liabilities together would decline by five

hundred million dollars as well Because remember you issued him

and raised five hundred million and now you're buying it

all back one hundred fifty million bucks cheaper and going

forward you would no longer Oh that twenty million dollars

a year You had been promising to pay bond investors

because well they don't know when your bonds anymore Some

companies have what are called call provisions for a modest

premium The company could and more or less whenever they

want retire some or all of its debt So let's

say that in this five hundred million dollars issue a

two percent call provision was embedded in the contract structure

the bond such that for one thousand twenty dollars a

unit or a total cost of five hundred ten million

dollars at any time the company wanted the company could

buy back his own bonds and just a retirement Well

why would a company want this call provisions Well you

can imagine a world where short term interest rates are

seven percent and long term rates are six percent and

the company believes and or hopes that interest rates will

go down over time Well if they do the company

would then obviously want the option to buy back its

high priced six percent bonds even if it has to

pay a bit of a premium to do so To

then be able to replace those expensive six percent bonds

with four and a half percent yielding bonds And somewhere

in the future well there exist myriad ways and structures

of dealing with bonds But for the purposes of this

course we're done rejoice So Joyce and then Joyce again

rejoice In real life the terms of a bond usually

gets set before the marketing roadshow happens with investment bankers

flying company management all over creation hoping to place and

you know say this five hundred million dollars worth of

bonds Let's say those bonds carry a face value six

percent interest paid twice a year to be fully retired

in seven years with lottery system of retirement that is

the bonds that any individual would buy would come in

thousand dollars units and each unit would have a serial

number in the same way a lottery ticket has an

identifying number As the bonds began to be retired the

lottery wheel spins and if your number is called your

Bond unit would be retired I either company would simply

buy back that bond likely at one hundred to percent

of its stated principle or something like that were set

another way It would pay a thousand twenty to buy

back and retire one unit of that thousand dollars Our

bond Well as the Roadshow coz you do a terrific

job marketing in presenting the company As a result the

perceived safety of your bonds goes up and the price

of the bonds which was said it a thousand dollars

also goes up That is when you actually go to

transact the thousand dollars par value bonds Well they sell

for eleven hundred dollars a ten percent premium over the

expected thousand dollar price per unit You know good for

you Note that an investor paying eleven hundred dollars for

a coupon of thirty dollars paid twice a year right

six percent interest or sixty dollars annually doesn't change They

still get that sixty bucks a year Only now they

paid eleven hundred dollars for that sixty dollars not a

thousand Essentially what happened is that their thousand dollars par

value bonds sold at a premium giving their interest rate

ah haircut from six percent down to five point four

percent Well things could have gone the other direction of

course had the mon sold at a discount The key

idea here is that bond prices and rates float in

a similar fashion to the way the equity stock market

floats and changes prices all the time Nothing other than

King Arthur's sword is set in stone