5.4 Accounting for Bonds- The Interest Method: Comparison of Bonds
The following is the effect of premium, par, or discount bonds over a 3-year horizon:
| Premium | Par | Discount | |
|---|---|---|---|
| Interest Expense | Low1 & Decreasing | Level | High & Increasing |
| Liability Balance (Amortization) |
Premium Decreases | Level | Discount Decreases (Liability Increases) |
Memo:
“Low” is used here to reflect that the interest expense is less than the coupon. Furthermore. each year the interest expense will be less than in the prior year- it is decreasing. In any case, the Interest Expense = $61,603 (Yr. 1); AND part of the Coupon Cash Flow goes to reduce the principal of premium bonds and vice versa for discount bonds. The Discount Bond will be exactly the opposite in its characteristics.
At maturity, $1mm is paid off even though there may have been different amounts received at the time of issuance – depending upon Market Value (Present Value).
The accountant, using the Interest Method, will make no adjustments over the life of the bond for changes in market yields subsequent to the date of issuance. As a result, the market value of the corporation’s debt is virtually certainly going to be different than the value at which the accountant reflects the bond on the balance sheet. It may, in fact, be more analytically correct to value the firm’s debt at current market discount rates rather than historical. This would yield a better view, or opinion, of the firm’s debt and financial ratios, and hence its true borrowing capacity.
Market rates are available from:
- Similar publicly traded debt (if not stated, this can be estimated);
- Add risk premium to Treasuries.
If rates have gone up since the issuance of the debt, the market value of the firm’s debt is lower, its solvency ratios are stronger, and its borrowing capacity has improved. If, alternatively, the firm is in financial distress or its financial condition otherwise changes, such changes in creditability will also be reflected in the bond’s YTM; that is, lower creditability will result in higher yields, and lower dollar prices.
It is not necessarily better or worse to issue bonds at a premium or discount. In the earlier example, the company paid $10,000 more per year (itself an annuity) in coupon interest versus the market yield (.07 – .06) × ($1,000,000). Incidentally, the PV of the three-year, $10,000 annuity at 6% = ($10,000) × (2.6730) = $26,710.
