 Hello, and welcome to the session. This is Professor Farhad in which we would look at a bound problem that could appear on the CPA exam as a simulation, or you might see in your intermediate accounting course. Now, why these problems are challenging or difficult for students? Three reasons. One, these type of problems would require you to understand and use the time value of money. And many students hate the time value of money. Two, you will need to understand the various accounts and how to do journal entries. Three, you need to understand how bonds work. So you need to understand all those three concepts in order to understand how to journalize and compute the price of the bond. The good news is, on my website, farhadlectures.com, if you're a CPA candidate or an accounting student, you can see detailed lessons about the bond topic. And you can master this topic, whether you are studying for your accounting course or taking your CPA exam. Also, if you just want to check your university, where does your university rank in terms of CPA exam performance? Before we start, just please connect with me on LinkedIn. If you haven't done so, subscribe to my YouTube channel, connect with me on Instagram and Facebook. Let's go ahead and get started. The Adam company issued a 12% bond dated January 1st with a face value of 90 million on January 1st, 2021. Let's explain everything. The company wanted to raise money. They decided to borrow money. They're willing to pay 12%, that's how much they're willing and able to pay, and the bond will be issued January 1st, so far so good. The bond mature on December 31st, 2030, so the life of the bond is 10 years. For bonds of similar risk and maturity, the market yields 14%. Now this is important. Why is this important? Well, they're telling us right here that you are not paying as much as the market. The market for similar bonds is paying 14%. You're paying 12, immediately. Immediately in your mind, if this was a multiple choice questions, you will need to choose the price of the bond. So the price of the bond, it's gonna be less than 90 million. So this bond will sell at a discount. So before you even do anything, you need to know that this is a discounted bond. It's gonna sell at a discount. Interest is paid semi-annually. This is important. It means rather than 10 years, we're gonna have N equal to 20. We have 20 periods because twice a year for 10 years is 20 periods. And the market rate rather than 14%, when we go to the table, you always use the market rate. We're gonna be using 7% to find the price of the bond. Okay? First, they want us to determine the price of the bond. And this is where your knowledge of the time, value of money comes into place. Do you know how to do this? Do you know how to compute the price of the bond? Well, the bond is composed of two things. When you find the price of the bond, I'm gonna give you the formula first. The price of the bond equal to the present value of payments, which is because they are the same, they're called annuity, plus the present value of face value, how much you're gonna get at the end of the life of the bond. Those two together, the present value of the payment, the present value of the face value. Now it's easy. The face value, how much will you get back, or you have to pay back, not get back because this is a liability. You're gonna have to pay back 90 million. So this is the face value. Now the payments, you have to know how to compute the payments. Now this is where you need to know the various formulas that deals with bonds. Well, the payment, how do you find the payment on the bond? The payment equal to the face value of the bond 90 million times the stated rate. So you have to be careful, because notice you have 12% and 14%. And you need to understand that your payment is based on what you issued the bond for. You issued the bond to pay 12%. This is the contract rate, 12%. However, this bond pays semi-annually, you multiply by half. So it's either annually or semi-annually. They don't give you quarterly. So be careful of it semi-annually to multiply by half. So the payment is 5.4 million every six month. So this is your payment. So this is your payment. Good. So I have the payment. I have the payment for 20 times. I'm gonna get the payment for 20 times and I equal to 7% because I'm gonna discount it. However, buys the bond from you, they want to earn 14%, which is 7% every six month. So therefore they will discount this, they will discount the bond based on that. So let's discount the payment first. So I'm gonna change colors here. So we're gonna take 5.4 million and we're gonna multiply it by the present value annuity factor. Well, we have to go to the tables. This is the present value of ordinary annuity. This is the present value of a dollar. You need to go because this is an annuity and this is an ordinary annuity. The first payment is due six month from now. We're gonna go to N equal to 20 right here. Let me change colors, make it red, it's better. N equal to 20, make it red right there. N equal to 20 and I equal to 7% and we're gonna come across and we're gonna find that the factor is 10.59401. So we're gonna take a 5.4 million times the present value annuity factor, 10.59401, okay? And this amount by itself, if we do this, it's gonna be 57 million, 57 million, 207,654. Now we have to do the same thing for the 90 million, same thing, but little differently. This is, we're gonna have to pay the 90 million only one time. Therefore, we're gonna go, again, use the same N, N equal to 20, I equal to 7. We'll use the same factor. When you go to the tables, you're always using the market rate. When you go to the table, you're always using the market rate. So now we're gonna do the same thing. N equal to 20, I equal to 7, and we're gonna come with this to this factor, 0.25842. So we're gonna multiply the 90,000, this 90,000 by, 90 million, not 90,000, by 0.25842, 0.25842. Oops, 0.25842. And that's gonna give us, for the face value, 23,257,800 dollars, okay? Now what we do is we add the present value for the payments, the present value of the single payment. And when we add them up, they will add up to 80,465,454. So this is the price of the bond. The price of the bond is composed of the present value of the payments, plus the present value of the face value. That's really good. Now we found the price of the bond and we answered the first question. And this could be a multiple choice questions. This could be a, basically, this could be a simulation by itself or a part of a simulation. So the price is 80,465,454. And I already told you, this bond will sell at a discount even before I did my computation. And what do I mean by discount? It means it's less than 90 million. You're not gonna get the 90 million. The company will never get the 90 million selling the bond, paying 12% because other bonds are paying 14. No one will pay you 90 million because they can go somewhere else and earn 14%. Why will they give you the 90 million to earn 6% because you're paying 6% every six months? Now we need to journalize the entry. Well, you always, if you know the amount of cash, you'll start with cash. So the company would receive cash 80,465,454. The next thing you do is you credit the bond. The bond is always credited for the face value. You are responsible for paying 90 million dollars. Although you received only 80 million today, well, the reason you received 80 million, 80.5 almost rounding is because you were not competitive. Your interest rate was not competitive. It's not competitive as the market. The difference between them is a discount on notes payable. Now you have to understand what the discount is. The discount is a contra liability. So let me make a T account called the discount. Let me call it just not note discount. My pen is not working properly. Give me one second, please. So this is the discount on bonds payable, BP bonds payable. Okay, now this account has 9,534,546. Okay, now the first thing you want to understand is what type of an account is a discount on bonds payable? What type of an account? This account is a contra liability. Okay, it means it reduces your liability. It's a contra liability. That's why it has a debit balance. Now also you have bonds payable, which is 90 million. So simply put, if I ask you today, what is the book value or the carrying value of the bond? The carrying value of the bond, and this is important, equal to 90 million, have enough zeros? Yes, enough zeros, minus 9,534,546. So the carrying value of the bond is 80,465,454. So this is the carrying value or the book value of the bond as of today, today is January 1st. So the carrying value of a discount bond, and this is an important number to know, because you will need this when you compute your interest. You will need this when you retire the bond early. So this is an important number. The carrying value of a discounted bond is the face value of the bond, which is 90 million, minus any un-amortized premium. We haven't amortized anything. Therefore, the book value is 80,465,454. Now six months later, you're gonna have to make your first payment, your first interest payment. Well, first start with your cash payment, even especially on the CPA exam, because you should know what your cash payment is. We already computed the cash payment equal to 5.4 million, credit cash 5.4 million. After you compute your cash payment, you compute your interest payment. Now be careful whether they're asking you to compute the interest based on the straight line or the effective rate. Most likely on the CPA exam, they would use the effective rate. Now how do you compute your interest using the effective rate? This is an important thing to know. How do you, how to compute this? So what you do is you take your beginning of the period book value, which is 80,465,004. Let me put it down here. You will take your beginning of the period book value, 80,465,454 times the market rate semi-annually, because everything is semi-annually times 7%. And this is gonna be your interest expense. This is gonna be your interest expense, which is it's gonna amount to, what's gonna amount to 5,632,582. That's your interest expense, 5,632,582. Hold on a second. I paid in cash 5.4 million. Why am I recording expense of 5.6 million, 5.6 million, 5.632 to be more specific, 582. Why? The reason why you are paying more interest, you are recording more interest expense is because when you issued this bond, you issued this bond at a discount. So this discount technically is interest expense, but what you do, you are gonna be amortizing, amortizing the interest expense over the life of the bond. How do you find out how much you're gonna amortize? You will take the difference between your cash. This is why I told you first to compute your cash, then compute your interest expense. The difference between them is the amount that you're gonna be amortizing. Simply put, you are going to amortize 232,582. Now what happened to your discount? Your discount went down. Your discount went down. It means you simply put your book, your carrying value or your book value went down, but let's compute the new amount of the discount. So let me give me one second here. Let me do this on my calculator, 9,534,546, minus 232,582, and that's gonna give you an amortized discount of 9,301,964. I hope my computation is right. Now we're done with the first payment. Now we're gonna do the second payment six months later, six months from June. Again, the first thing is your cash. Your cash is 5.4 million. Your cash payment would always be the same for the bond. Then we have to compute the interest expense, and here you have to be very careful. You have to compute your carrying value. What happened to your carrying value? Actually, your carrying value went up. Why did your carrying value went up? Because your discount went down. Now what's your new carrying value? Again, how do you compute the carrying value? It's the 90 million minus any un-amortized discount. Now you only have 9,301,964. So let's compute your new book value because based on your book value, you will compute your interest expense. So we're gonna take 90 million minus 9,301,964, and that's gonna give us a book value of 80 million, 6,98,036. Now we're gonna take 80 million, 6,98,036, times 7%, times 0.07. And that's gonna give us interest expense of 5,648,863 rounding, 863. So this is my interest expense. So this is my interest expense. Notice my interest expense is higher than the previous period. This should make sense because my book value went up and my book value will keep going up until it becomes 90 million. Until basically, it means 90 million. Eventually this will be the zero. All the discount will be gone. Now I'm gonna, again, reduce my discount by the difference between the two. So I'm gonna reduce my discount by 200,000. By 248,863. And I will have a new discount on bond and the process will keep repeating itself. The process will keep repeating itself. Again, my discount will go down. My book value will go up. My interest expense will go up. But my cash payment will always be the same. And eventually, if you do this for 20 periods, if you do this for 20 periods, your discount will go down to zero. And once your discount go down to zero after 20 periods, your bond will go back to its face value of 90 million. So this is how you price the bond. Price the bond means find the price of the bond. Then you journalize the entries. Now also, maybe in another problem or if you wanna go a little bit further, you need to maybe prepare an amortization schedule for this. I do have this on my website. Again, you can go to my website, farhatlectures.com to find additional resources about this topic. I do cover bonds and notes payable and time value of money in details, whether you are an accounting student or studying for your CPA exam. If you are studying for your CPA exam, don't take any shortcuts. My subscription is nominal in the long run. What I'm doing is I'm asking you for $30 to improve your chances substantially to pass your exam. That's gonna open up a wide variety of careers options in front of you for the next 40 years. Don't shortchange yourself. I'm helping you here. Help yourself, steady hard, good luck, and stay safe.