Accounting: Accounting for Bonds, James Bonds
Recommendation
Want a study guide too?
Courses | Accounting |
Language | English Language |
Transcript
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