Bonds II: Issuance Costs, Fair Value, Debt Covenants & Disclosures | 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.

In this tutorial, we’ll dive into part 2 of bonds, covering the effects of issuance costs of bonds, the fair value reporting option, debt covenants, and the required presentation and disclosures on financial statements.

A Quick Recap of Bonds I

Before diving in, let’s quickly revise what we learned in the previous lesson:

• When a bond is issued at a discount, cash received is recorded on the balance sheet with a corresponding bond liability.
• The liability increases over time to the face value of $100,000 at maturity.
• Interest expense on the income statement equals the book value multiplied by the effective rate.
• In the statement of cash flow, the issue proceeds are reported as a cash inflow from financing activities.
• Under US GAAP, coupon payments are reported as CFO, while 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.

Issuance Costs and Accounting Issues

Issuing a bond involves legal and accounting fees, printing costs, sales commissions, and other fees. Let’s see how these issuance costs are handled under U.S. GAAP and IFRS:

U.S. GAAP:

• Issuance costs are capitalized as a deferred charge.
• This capitalized asset is allocated to the income statement as an expense over the term of the bond.
• On the cash flow statement, issuance costs are netted against bond proceeds and reported as a financing cash flow.

IFRS:

• Initial bond liability on the balance sheet is reduced by the amount of issuance costs.
• This increases the bond’s effective interest rate.
• First year interest expense is calculated based on the increased effective rate.
• Issuance costs are treated as unamortized discount under IFRS.
• Like U.S. GAAP, bond issuance costs are netted against bond proceeds and reported as a financing cash flow.

Fair Value Reporting Option

Market yields of bonds may fluctuate, causing differences between the market price of the bond and the book value of the bond liability. In some cases, it may be more accurate to value the bond at fair value instead. Both IFRS and US GAAP provide firms the irrevocable option to report debt at fair value. Gains and losses resulting from changes in bonds’ market price are reported in the income statement.

Derecognition of Debt

When a bond is derecognized at maturity, its book value and face value are the same. However, bonds can be redeemed before maturity, which may lead to differences between the market price and book value. In such cases, the gain or loss is reported in the income statement, usually under continuing operations.

Debt Covenants

Debt covenants are restrictions imposed by lenders to protect their position, reduce default risk, and potentially lower borrowing costs. These restrictions can be in the form of affirmative covenants or negative covenants.

Affirmative covenants require the borrower to do certain things, such as:

• Make timely principal and interest payments.
• Maintain specific ratios (e.g., current, debt-to-equity, and interest coverage ratios).
• Keep collateral, if any, in working order.

Negative covenants require the borrower to refrain from activities that might adversely affect their ability to repay, such as:

• Increasing dividends or repurchasing shares.
• Issuing more debt.
• Engaging in mergers and acquisitions.

Bond covenants are typically discussed in the financial statement footnotes. If a borrower violates any of the covenants, a technical default occurs, and the bondholder can demand immediate repayment of the principal.

An analyst should study covenants when valuing a firm’s equity, as these restrictions may affect the firm’s growth prospects.

Required Presentation and Disclosures

Firms usually report all outstanding long-term debt on a single line on the balance sheet. The portion due within the next year is reported as a current liability, and the rest as a non-current liability. More details about the long-term debt are often disclosed in the footnotes, which may be useful in determining the timing and amounts of future cash outflows.

Footnote disclosure typically includes:

• Nature of the liabilities
• Maturity dates
• Stated and effective interest rates
• Call provisions and conversion privileges
• Restrictions imposed by creditors
• Assets pledged as security
• Amount of debt maturing in each of the next five years

A discussion of the firm’s long-term debt can also be found in the Management Discussion and Analysis section, which may include quantitative analysis (e.g., obligations due to mature in the future) and qualitative discussion (e.g., trends in the firm’s capital structure and material changes in the mix and cost of debt).

Conclusion

That wraps up this second part on bonds, where we discussed issuance costs, the fair value reporting option, debt covenants, and required presentation and disclosures on financial statements. In our next lesson, we’ll move on to leases.