Bond HELP!

[AJF]

Can I get some clarification here?

1-When bonds are originally issued and put on the B/S are done so at their PVs? Or is that only for zero coupons? I.e. if a p-bonds was issued at 1020, would the BV be 1020*number of bonds or PV of bond?

2-Do you adjust the long-term debt account on the B/S for the amortization expense for each period? I.e. do you add subtract it for p-bonds and add it for d-bonds?

3-Can you tell me if I have this correct, for zero coupons-your CFO is overstated all of the time b/c there is no interest being paid or amortization. The amortization is only accounted for at maturity in CFF when you pay out par?

Some of these questions might sound silly, but very important to my basic understanding!

Thanks in advance for your help!

 

[jamespucyk]

1) Liability on the BS is the PV of the bond based upon the going market rate. Interest expense is equal to the effective interest rate (discount rate of the bond) times the liability and then the difference between the coupon and the interest expense is equal to the amoritization of the discount or premium of the bond.

2) Yes, coupon interest will exceed interest expense for a premium bond, that difference goes to amoritize (reduce) the premium. Interest expense will exceed coupon interest for a discount bond, the difference will go to increase the liability; reduce the discount.

3) You are wrong and you are right at the same time. CFO will be overstated because over the life of the 0-coupon because there will be no cash interst payments, no recognition in the cash flow statement. Interest expense will still be recognized on the IS and the whole interest expense will serve to amoritize the discount. And in the CFF there will be a par value cash-outflow at maturity of the bond.



Edited 1 time(s). Last edit at Saturday, April 29, 2006 at 01:50PM by jamespucyk.

 

[AJF]

Thanks James (I am assuming),

What is your background? you are always so quick to help those in need on this phorum and I am personally grateful for that.

For #3, how can interest expense be recognized on the IS and not on the Cash flow statement, considering you start with NI?

Does this "interest expense" just go to CFF?

Thnx

 

[jamespucyk]

Not a problem, I work for a brokerage and have a economics degree.

Interest expense is a function of the discount rate of the bond times the liability at the beginning of the period, so it's coupon payment plus or minus the amoritization of the premium or discount. On the statement of cash flows only the coupon payment is recognized the amoritization is not since it is a non-cash charge.

No CFF has nothing to do with interest expense.

You really should read the chapter on liabilities too.

 

[AJF]

Thanks again. This makes a big difference!

A

 

[jamespucyk]

Not a prob. I know some of the explainations in that chapter seemed a little trite to me when I read them too.

 

[CFAHouston]

"you are always so quick to help those in need on this phorum and I am personally grateful for that. "

He's our guru of AF level 1



Edited 1 time(s). Last edit at Saturday, April 29, 2006 at 10:15PM by CFAHouston.

 

[AJF]

I went back and read the liab chapter and I am still confused about the amortization of the prem/discount

For a discount bond, your interest expense on the I/S will effective rate*PV of remaining int + principal. Part of which will be actual interest expense (coupon) and the other portion will be classifed as amortization. Which will be added back to CFO as a non cash charge. Is this correct?

For a premium, the total interest expense on the I/S will be less, but where on the I/S do you show the amortization of the premium?

Confused in Canada.

 

[jamespucyk]

Thanks Houston, I appreciate it. I like to review what's already in my head in another forum other than on tests and if I help that's even better.

1) For ANY bond the interest expense is the effective rate * PV (at the time, beginning of the period) of ALL cash flows principal and coupons. Part of the interest expense is actually the coupon, the difference between the IE and the Coupon goes to amoritize a bond (notice that I said IE - Coupon, so if it's negative you amoritize the premium and if positive, in the case of a discount it goes to "positively" amoritize the discount.

On the Cash Flow statement only cash is recognized so any amoritization is adjusted for and we are left with the coupon. Think about it like this, if the IE for premium bond and a discount are 4k and 6K respectively, they may have a coupon of 5k, so the the negative 1k amoritization (4k-5k) for the premium and positive 1k difference for the discount bond (6k - 5k) are all adjusted for (i.e. the non cash negative amoritization will be added to the IE and the positive taken away from the IE on the Cash flow statement), leaving us with 5k for each.

2) The amoritization is included in the interest expense (debit) on the IS, the adjustment on the BS is effectively (for a discount bond):

Income Statement:
IE = 6k (Db)

BS
Interest Payable = 5k (Debit)
Cash = 5k (Credit)
Unamoritized Bond Discount = 1k (Debit)
Long Term Debt = 1k (Credit)

 

[AJF]

Great! I have finally got it-thanks to you! I was so confused with the amortization termminology!

 

[jamespucyk]

I'm glad to head it and glad I can help. I know some of the material, especially in for White Analysis jumps from one thing to another.