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ACCOUNTING Allah shmoop Accounting for Bonds James Bonds All right

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Your tractor company tread on me needs cash to grow

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It needs money to open up foreign offices It needs

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money to increase the size of its tractor smelting plant

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It needs innovation from its RND or research and development

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People love in their labs you know to make self

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driving tractors so that it never suffers Another Teamstersstrike at

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still scarred from that your company decides that now five

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hundred million dollars in debt would do nicely so that

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it can actually do well of these things and have

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

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so awesome The question you are given then revolves around

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how you account for the issuance payment interest and then

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

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

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

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day that you actually issue the bonds to bond investors

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I sell them bonds You will have to put it

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double entry on your balance sheet to account for this

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

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collecting five hundred million dollars in cash on that day

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your cash account will go up by the five hundred

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million bucks you just raised and your long term liability

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account will also go up by five hundred million dollars

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Okay big fat hairy detail here So note carefully Yeah

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

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see if you really get this difficult set of concepts

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Here we go So the bonds cost four percent in

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

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paid down to zero dollars in seven years But with

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no principal paydown required in year one or two in

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year three of the company must begin paydown of twenty

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five million dollars per quarter or one hundred million dollars

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per year each year for five years until the bonds

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are totally paid off Could the company two plus years

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later issue more bonds to pay off the previous bonds

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Oh you bet California Illinois and other blue states have

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relied on this continued bond issuance to stave off bankruptcy

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for decades So why not in corporate America to write

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Well anyway here is what the payments will look like

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over the next seven years So a year passes and

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on the annual income statement you show a line expense

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labeled bond interest and you would put in their twenty

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million dollars Why twenty Well you borrowed five hundred million

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dollars at four percent annual interest to incur total interest

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for the year of twenty million dollars which you likely

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pay off twice a year The way normal bond interest

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is paid a ten million bucks so that twenty million

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dollars was your cost of renting the five hundred million

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dollars for that year No principles a down member in

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your one and or two Did anything else change No

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but a few things were about to note that the

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bond principle was placed as a long term liability on

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the balance sheet The definition of long term means do

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in a year or longer Note also that after this

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first year passes well the first principle stay down requirements

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of the bond will continue on to be within one

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year So as we get into the first quarter of

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the second year after having rented that five hundred million

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box each corridor another twenty five million will shift from

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the balance sheet on the long term liability ass IG

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

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go from being a do a year or more to

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being Teo within a year said another way Eighteen months

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after having borrowed the five hundred million dollars a balance

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sheet will show long term liability of four hundred fifty

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million and short term liability of fifty million Okay so

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

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the money The principal paydown requirement began after two years

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

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bucks each year As per the bond requirement you now

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owe two hundred million dollars for one hundred million dollars

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being a short term liability hundred million dollars being a

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long term liability So the offset on the declining numbers

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in the liability sections of the bank NJ would have

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come from your cash account declining as you sent out

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cash in chunks of twenty five million dollars for principle

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plus whatever interest was owed for the money being paid

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off And note that as you pay the principal down

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you owe less rent on it or less interest So

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

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owed two hundred million dollars remaining on your bond thing

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

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million dollars because your principal has gone from five hundred

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million dollars at which point you were paying twenty million

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dollars a year to now Just going two hundred million

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dollars and four percent of two hundred million is eight

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million bucks Well as you continue paying down the principle

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

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rent on that debt goes down As any New Yorker

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

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control So here is another big fat curveball to drive

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you crazy or humble you If you think you really

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understand bond accounting at this point I suppose your debt

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is publicly traded Its value fluctuates daily such that the

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marketplace at times values the five hundred million you borrowed

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at five hundred twenty million IEA prizes your debt essentially

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giving that debt a lower interest rate Because odds are

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good you pay it off by it out early or

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something like that and at other times the debt trades

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cheap But only four hundred seventy five million dollars such

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that someone buying into that four percent interest rate debt

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is getting mohr than four percent interest from it right

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The company still pays the twenty million dollars a year

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

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seventy five because four percent was pegged on that five

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hundred million dollars you issue right Twenty million dollars no

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matter what does the daily trading valuation matter to you

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Is an accountant Short answer No But what would happen

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if your company was doing reasonably well And for whatever

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reason the Fed decided to suddenly raise interest rates dramatically

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at the same time crashing the price of your bonds

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Well could you Is a company go into the market

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and then buy back your own bonds Well you could

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

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Buy back your own dead as well If the bonds

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which were at par of a thousand dollars a unit

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suddenly cratered to trade for only six hundred dollars a

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unit While you could in theory go into the market

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after filing all kinds of legal disclaimers and waivers and

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

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what your doings of the entire world knew every little

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detail Then you could offer or tender for your own

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bonds at saying sixty five cents on the dollar Maybe

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having just sold them eighteen months earlier for a hundred

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cents on the dollar Well how would you account for

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this Well you would add a new line on the

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expenses line of your income statement showing an expense of

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retirement of outstanding debt You would then look to your

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balance sheet where cash one out the door of saving

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three hundred fifty million that is your cash account would

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decline by three hundred fifty million dollars But then here

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short and long term liabilities together would decline by five

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hundred million dollars as well Because remember you issued him

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

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all back one hundred fifty million bucks cheaper and going

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forward you would no longer Oh that twenty million dollars

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a year You had been promising to pay bond investors

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

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companies have what are called call provisions for a modest

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premium The company could and more or less whenever they

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

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say that in this five hundred million dollars issue a

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two percent call provision was embedded in the contract structure

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the bond such that for one thousand twenty dollars a

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unit or a total cost of five hundred ten million

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dollars at any time the company wanted the company could

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buy back his own bonds and just a retirement Well

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why would a company want this call provisions Well you

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can imagine a world where short term interest rates are

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seven percent and long term rates are six percent and

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the company believes and or hopes that interest rates will

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go down over time Well if they do the company

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would then obviously want the option to buy back its

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high priced six percent bonds even if it has to

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pay a bit of a premium to do so To

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then be able to replace those expensive six percent bonds

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with four and a half percent yielding bonds And somewhere

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in the future well there exist myriad ways and structures

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of dealing with bonds But for the purposes of this

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

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rejoice In real life the terms of a bond usually

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gets set before the marketing roadshow happens with investment bankers

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flying company management all over creation hoping to place and

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you know say this five hundred million dollars worth of

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

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percent interest paid twice a year to be fully retired

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in seven years with lottery system of retirement that is

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the bonds that any individual would buy would come in

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thousand dollars units and each unit would have a serial

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number in the same way a lottery ticket has an

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identifying number As the bonds began to be retired the

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lottery wheel spins and if your number is called your

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Bond unit would be retired I either company would simply

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buy back that bond likely at one hundred to percent

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of its stated principle or something like that were set

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another way It would pay a thousand twenty to buy

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back and retire one unit of that thousand dollars Our

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bond Well as the Roadshow coz you do a terrific

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job marketing in presenting the company As a result the

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perceived safety of your bonds goes up and the price

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of the bonds which was said it a thousand dollars

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also goes up That is when you actually go to

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transact the thousand dollars par value bonds Well they sell

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for eleven hundred dollars a ten percent premium over the

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expected thousand dollar price per unit You know good for

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you Note that an investor paying eleven hundred dollars for

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a coupon of thirty dollars paid twice a year right

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

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still get that sixty bucks a year Only now they

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paid eleven hundred dollars for that sixty dollars not a

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thousand Essentially what happened is that their thousand dollars par

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value bonds sold at a premium giving their interest rate

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ah haircut from six percent down to five point four

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percent Well things could have gone the other direction of

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course had the mon sold at a discount The key

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idea here is that bond prices and rates float in

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a similar fashion to the way the equity stock market

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floats and changes prices all the time Nothing other than

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King Arthur's sword is set in stone

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