Non-Current Liabilities: Bonds I | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Non-current liabilities can include long-term debt, such as bonds and long-term notes, finance leases, pension liabilities, and deferred tax liabilities. This topic focuses on bonds and leases, as well as an introduction on pension liabilities.

In this first part, we shall learn about bond issuance.

Understanding Bonds

A bond is a contract between a lender, and a borrower. The lender is also known as the bondholder, while the borrower is also known as the bond issuer.

There are 4 important components stated on the bond:

• Maturity date: This is the date that the principle will be returned to the bondholder, and the contract completed.
• Face value or par value: This is the amount of principle that will be paid to the bondholder on the maturity date.
• Coupon rate: This is the stated interest that is used to calculate the periodic interest payment to the bondholder.
• Payout frequency: Most coupon bearing bonds pay out coupons semi-annually.

Example of Bond Issuance

Let us assume that this is a new bond issue that will mature in 3 years time, with a face value of $100,000, a coupon rate of 6%, which is to be paid out annually.

At issuance, there are 3 scenarios that can happen. The bond can be issued at par value, at a discount, or at a premium. Let’s examine the implications of each of these scenarios.

Bonds Issued at Par

When a bond is issued at par, the lender pays the bond issuer the exact face value of the bond, which in this case is $100,000. In return, the lender is promised regular coupon payments, and the return of the par value at maturity. The coupon payment is calculated by multiplying the coupon rate with the face value.

So in this case, the lender pays $100,000 to the bond issuer to buy the bond. For the next 3 years, the bond issuer is obligated to make annual coupon payments of $6,000 each time. The face value of $100,000 will be repaid to the bondholder on the maturity date.

A frequently quoted attribute of a bond is the effective interest rate of the bond. Not to be confused with the coupon rate, the effective rate is the interest rate that equates the present value of the future cash flows, with the issue price. If you punch in these figures into your calculator, you will derive an effective interest rate of 6%.

This coincides with the coupon rate! In fact, the only time the effective interest rate will coincide with the coupon rate is when the bond is issued at par.

Financial Statement Effects: Bonds Issued at Par

The effects on the financial statements are straightforward for a bond issued at par:

• Balance sheet: The assets and liabilities increase in equal amounts by the bond proceeds, which in this case is the face value of $100,000. The book value of the bond liability will not change over the term of the bond, as the bond is issued at par.
• Income statement: The interest expense for the period is equal to the coupon payment of $6,000 per period. This is because the effective interest rate at issuance, and the coupon rate are the same.
• Statement of cash flows: The proceeds of $100,000 from the bond issuance are reported as a cash inflow from financing activities. The coupon payments are reported as cash outflows from operating activities under US GAAP. Under IFRS, they may be reported as CFO or CFF.
• At maturity: The repayment of the face value is reported as a cash outflow from financing, and the cash and bond liability are removed from the balance sheet.

Bonds Issued at a Discount

When a bond is issued at a price that is lower than its par value, it is said to be issued at a discount. Let’s say, for example, that this bond gets issued at a discounted price of $96,099. The lender is still promised the same regular coupon payments of $6,000 each year, and the return of the par value of $100,000 at maturity. The only difference here is that the lender paid a lower price of $96,099 for the same bond.

This has an effect on the effective rate, and the reporting on the bond issuer’s financial statement.

Firstly, the effective interest rate will be higher. If you punch these figures into your time value of money calculator, you will derive an effective interest rate of 7.5%, which is higher than the quoted coupon rate of 6%.

Financial Statement Effects: Bonds Issued at a Discount

For bonds issued at a discount, the financial statement effects include:

• Balance sheet: The issuer only received $96,099 cash. As such, assets increase by $96,099. To balance the equation, a corresponding increase of bond liability of the same amount is also recorded. This liability increases over time to the face value of $100,000 at maturity. Its book value is equal to the present value of the remaining cash flows, discounted at the effective interest rate at issuance.
• Income statement: The interest expense is equal to the book value, multiplied by the effective rate. For the first year, the book value of the bond liability is $96,099. Multiply this by the effective rate of 7.5%, we get a first-year interest expense of $7,207. The interest expense actually increases over time as the book value of the liability increases to the face value at maturity.
• Statement of cash flows: The issue proceeds of $96,099 are reported as a cash inflow from financing activities. The coupon payments are reported as cash outflows from operating activities under US GAAP. Under IFRS, they may be reported as CFO or CFF. Note that the cash outflow is $6,000, as it is the actual coupon payment amount made to the bondholder. This should not be confused with the $7,207 interest expense recorded on the income statement.
• At maturity: The repayment of the face value of $100,000 is reported as a cash outflow from financing, and the cash and bond liability of $100,000 each are removed from the balance sheet.

Bonds Issued at a Premium

When a bond is issued at a price that is higher than its par value, it is said to be issued at a premium. Let’s say, for example, that this bond gets issued at a premium price of $105,550. Likewise, the lender is still promised the same regular coupon payments of $6,000 each year, and the return of the par value of $100,000 at maturity. The only difference here is that the lender paid a premium of $5,550 for the same bond.

Let’s calculate the effective interest rate if the bond is bought at this price. Punch these figures into your time value of money calculator, and we get an effective rate of 4.0%, which is lower than the quoted coupon rate of 6%.

Financial Statement Effects: Bonds Issued at a Premium

For bonds issued at a premium, the financial statement effects include:

• Balance sheet: The issuer received $105,550 cash. As such, assets increase by this amount. To balance the equation, a corresponding increase of bond liability of the same amount is also recorded. This liability decreases over time to the face value of $100,000 at maturity.
• Income statement: The interest expense is equal to the book value, multiplied by the effective rate. For the first year, the book value of the bond liability is $105,550. Multiply this by the effective rate of 4.0%, we get a first-year interest expense of $4,222. The interest expense actually decreases over time as the book value of the liability decreases to the face value at maturity.
• Statement of cash flows: The issue proceeds of $105,550 are reported as a cash inflow from financing activities. The coupon payments are reported as cash outflows from operating activities under US GAAP. Under IFRS, they may be reported as CFO or CFF.
• At maturity: The repayment of the face value of $100,000 is reported as a cash outflow from financing, and the cash and bond liability of $100,000 each are removed from the balance sheet.

Bond Amortization: Premium and Discount

As discussed earlier, bonds can be issued at a discount or a premium. In both cases, the difference between the issuance price and the face value must be amortized over the bond’s life. This process is called premium or discount amortization. There are two methods of amortization: the effective interest method and the straight-line method.

Effective Interest Method

The effective interest method is required under IFRS and preferred under US GAAP. We demonstrated this method in the previous examples. It involves calculating the interest expense as the beginning book value of the bond liability multiplied by the effective interest rate. The difference between the interest expense and the coupon payment is the discount or premium amortization.

Straight-Line Method

The straight-line method is not allowed under IFRS but is permitted under US GAAP if the results are not materially different from the effective interest method. With this method, the discount or premium amortization is constant throughout the life of the bond. It is calculated as the total discount or premium divided by the number of periods to maturity.

Zero-Coupon Bonds

Zero-coupon bonds, also known as pure-discount bonds, are issued at a discount from their par value and make no periodic interest payments. The effective interest rate of these bonds is usually lower compared to their regular counterparts. The issuer prices the bond such that it offers a similar yield to an investor.

When amortizing a zero-coupon bond, the interest expense is the beginning book value multiplied by the effective interest rate, and the discount amortization is the full interest expense. No coupon payments are made, but the bond issuer must still account for the interest expense over the years in its income statement.

Conclusion

In this lesson, we have covered the financial statement effects of issuing a bond at par, discount, or premium. It is essential to understand how to calculate the book value, interest expense, and bond amortization at any point in time using the effective interest rate method.

In the next lesson, we will discuss the effects of issuance cost, the fair value reporting option, derecognition of debt, and the required disclosures regarding debt.