Non current or long term liabilities represent loss of economic benefits over the future period of greater than a year. Non current liabilities generally reported on a company’s financial statements are bond payable (long term debt), financial leases and pension liabilities. In this series we will cover bonds payable and financial leases.
See the following posts for definition of current liabilities and assets and also the list of long term liabilities and assets.
Bond payable definition
A bond is a security against which debt is raised by a company. A bond payable is a contract between the issuer of the bond (borrower) and the bondholder (lender) that obligates the bond issuer to make periodical interest payments to the bondholder over the life of the bond and to return the principal to the bondholder on maturity of the bond.
The amount at which the bond is issued is called the face value of the bond. It is also known as principal (as it is the amount invested by lenders) or par value or stated value. It is also known as maturity value as it is returnable to the bond holders on maturity.
Periodic interest payments made to the bond holders are also known as coupon payments. Coupon payments are made at the coupon rate, also known as the stated rate as it is stated on the bond. This rate remains unchanged throughout the currency of the bond.
Market rate or market yield is the rate demanded by the purchasers of the bond as per their level of perceived risk. Market rate is the rate which equates the present value of the future cash flows of the bond to its market price. It is not same thing as the coupon rate. This rate can fluctuate in time between the bond is issued and it matures, depending upon the interest rate fluctuations, demand and supply of the bonds and perceived risk among various other factors. When the risk perceived is higher, the yield demanded is higher than when the perceived risk is low. Higher the yield lower the price of the bond, lower the yield higher the price of the bond.
If at the time of issuance of the bond, the market rate is the same as the coupon rate, the bond is issued at par (at face value). If the market rate is higher than the coupon rate, the bond is issued at a discount to par and if the market rate is lesser than the coupon rate, the bond is issued at a premium.
This can be understood intuitively. We know that market rate is the rate that equates the present value of the future cash flows of the bond to its market price. Therefore, if the market yield (i.e. the discount rate) is the same as the coupon rate, wouldn’t the market price (i.e. present value of future cash flows) of the bond be the same as its issue price or face value or par value whatever you call it?
Similarly, if the market yield demanded is higher than the coupon, the bond will trade at a price lower than the par value (higher the discount rate, lower the present value). It can be also be looked at this way – the market will be willing to pay only a lower price to extract a higher yield.
In the same fashion, when the market yield demanded is lower than the coupon rate, the bond will trade at a premium to par (lower the discount rate higher the present value) i.e. the market is willing to a pay a price higher than the face value of the bond as is satisfied with a lower yield.
So how does issuing bond affect the balance sheet?
Bond issuance is shown on the balance sheet as a liability. The book value or carrying value of the bond payable is valued at the present value of the remaining cash flows i.e. the coupon payments plus the maturity value discounted at the market rate at the time of issuance. At maturity the book value is equal to the par value of the bond payable.
On the balance sheet, assets (cash) and liabilities (bond liability) both increase by the proceeds received from the bond issuance. The book value of the bond liability does not change over the currency of the bond payable in case of a par issuance as the market rate at the time of issuance (discount rate) is the same as the coupon rate.
A premium bond is reported on the balance sheet at more than the face value. As the premium is amortized over the life of the bond, the carrying value will reduce until it reaches par value at maturity. Similarly in case of a discount bond, the carrying value will increase (when discount is amortized it is added) until it reaches par value at maturity.
How do bonds affect the income statement?
Interest expense is reported on the income statement. It is calculated by multiplying the book value of the bond payable at the beginning of the accounting period with the market rate at the time of issuance. In case of a par bond it is equal to coupon payment.
Debt issuance costs on cash flow statement
On the cash flow statement the proceeds from issuance will be shown as financing cash inflow and coupon payments will be recorded as operating cash outflows, under GAAP and operating cash flow or financing cash flow under IFRS. Maturity repayment is recorded as financing cash outflow.
That’s all in this post guys…stay posted for more on this topic…..and don’t forget to share…
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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