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CFA Level 1 - Long-Term Liability Basics A. Long-Term Liabilities
I.Basics
Reporting Debt Issues
A company can issue debt securities to finance its operations. These debt securities are bonds. A bond is a promise, in most cases, 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 get $1m for the bond.
Bonds that are issued with coupon payments that are not equal to the current interest rate are said to be issued at a "premium" or "discount". If Company ABC issues a bond that will pay 9% a year for five years and similar bonds are paying 10%, why would investors buy Company ABC's bond if they can purchase the other bond that will give them 10%. The only way they will purchase the bond is if the company sells the bond at a discount of it 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. If Company ABC issues a bond that will pay 10% a year for five years and similar bonds are paying 9%, why would the company pay more to investors? 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 utilizing 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.
Next: CFA Level 1 - Journal Entries and Accounting Impact
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