CFA Level 1
Liabilities - Long-Term Liability Basics
Reporting Debt Issues
In addition to raising capital from stock issuance, many companies issue debt securities in the form of bonds to finance their operations. A bond is essentially an IOU or promise to pay a predetermined annual or semiannual interest payment and to pay back the principal (face value) when the bond matures. When a company issues a bond with coupon payments that are equal to the current market rate, the bond is said to be issued at par. From an accounting point of view this means that if a company issues a $1M bond at par the company will in return have raised $1M in capital for its efforts. When bonds are issued with coupon payments that are not equal to the current market interest rate they are considered to be issued at a "premium" or "discount" to or from par. Companies that are very active in bond issuance issue bonds at par more frequently than those companies that are not as active.
Example of bonds issued at a discount:
Company ABC issues a bond that will pay 9% a year for five years and similar bonds trading are paying currently paying 10%.While there are multiple market related factors that determine the issuing price (supply and demand, credit ratings, analysts' opinions, state of the economy and yield curve characteristics) in this simplistic example the bonds would most like be issued at a discount to its par value to compensate for the lower coupon payments. The company will ultimately get less money for its bond than the stated par value and is said to sell at a discount.
Example of bonds issued at a premium:
Company ABC issues a bond that will pay 10% a year for five years and similar bonds are currently paying 9%. The only way the company will sell this bond to investors is if the company sells the bond at a premium to its par value (for more money) to compensate the company for the paying a higher coupon. The company will ultimately get more money for its bond than the stated par value, and the bond is said to sell at a premium.
From an accounting standpoint, a company that sells a bond at a discount (or premium) will record on a cash basis a smaller interest payment but in reality will have a higher interest expense because it received fewer dollars for its bond. In accordance with the matching principle, premium and discounts must be amortized over the life of the bond. U.S. GAAP allows companies to amortize premiums or discounts by using a straight-line amortization or the effective interest rate method.
Discount vs. Premium Pricing
If coupon = to market rate, the bond is issued at par.
If coupon > market rate, the bond is issued at a premium. The issuing company will get more money at initiation than it will pay to investors at maturity. In exchange it will pay a higher coupon than it would have to if the bond was issued at par.
If coupon < market rate, the bond is issued at a discount. The issuing company will get less money at initiation than it will pay to investors at maturity. In exchange it will pay a lower coupon than it would have to if the bond was issued at par.