 Oh, and welcome to the session in which you would look at bonds. This topic is important for accounting students as well as CPA candidate. So what is the big idea behind bonds? Well, bonds is basically borrowing money from various creditors rather from one source. So one way to borrow money is go to the bank and ask the bank for money. Well, sometimes the amount is too large or the amount is risky for the bank, so they will not give you the money. So as a result, what happened is you will use another tool to raise money from many creditors. So used when the amount is too large for one creditor, therefore you would rely on various creditors. So how would you rely on various creditors? Well, you will show a bond contract or bond indenture. And in that bond indenture, you promise the creditors, the people, the institution, the companies that are giving you money that you're going to pay them back. That's in the contract plus interest. So what does the bond represent? The bond represent a promise to pay a sum of amount of money at a designated maturity date plus periodic interest payment. So I want you to do now. I want you to start to think about what a bond would look like. This is what a bond would look like. The bond, when you buy a bond, you're going to be getting periodic interest payment. Obviously, then you're going to get your amount, the amount that you lent. So you're going to get periodic interest payment. For example, every year, year one, year two, year three, and year four, then you're going to get your money back. This is basically how borrowing work. And this is what a bond looks like. Now companies usually issue bonds in $1,000 denomination or face value. What does that mean? It means you can buy a bond if you have a $1,000. Buying a bond means lending the money to the company that's trying to raise the money. And that's why by issuing bonds, you can have anyone participating willing to take the risk to buy your bond. Now interest payment usually are made semi-annually. And here we are discussing US corporate bonds because there are many types of bonds, government bond, non-government bonds, so on and so forth. For the purpose of this session and for the purpose of financial accounting, intermediate accounting, the CPA exam, we're going to be using US corporate bonds. And there are many different type of bonds. Maybe I will have a different session for that. But for this session, we will use US corporate bond. So let's see what a bond would look like. The bond will have an issue date. For example, January 1st, 2020 X2. This is when the bond is issued. It means sold to the public. And the bond will have a maturity date. And here we are going to say December 31st, 2020 X4. So this bond is for two years. Also, the bond will have what's called the face value or the par value or the maturity value. All those three means the same thing. And for this bond, the company is trying to raise $100,000. This is the face value of the bond, the maturity, or the par value. What does that mean? It means if you buy this bond, this bond specifically, that's in front of you, you will get back the face value. If you look at a $20 or a $50 bill or a $100 bill, the amount is written on it on the face value. So this bond will have a face value of $100,000. Now you may give the company initially $90,000 or you may give the company $110,000 to buy this piece of paper and we'll see why you will pay a different price. But the amount you will get at maturity is $100,000. So December 31st, 2024, whoever's carrying this piece of paper will get $100,000, which is the maturity value or the face value. Now there's some lot of terminology in this chapter. The bond will pay interest. And they will pay interest. We said it's going to be semi-annually for our purpose, July 1st and December 31st. So those are the interest payment dates twice a year. And that's going to make a difference because we're paying interest twice a year. It means this bond will compound semi-annually. Also, if you're paying interest, you have to have a stated rate. You have to tell the people that's giving you the money, the creditors. You have to tell them how much you're willing to pay them. And for this bond, for this illustration, the stated rate is 8%. Sometimes the stated rate is called the offering rate. Sometimes it's called the coupon rate. Sometimes it's called the contract rate. Sometimes it's called the nominal rate. Depending on your textbook, depending on your CPA review course, they all mean the same thing. I like to use the stated rate. Or I also sometimes use the printed rate. To remind the student that the rate is stated and it does not change, it's printed. And you're going to see why that's going to be a relevant piece of information later on. Of course, the bond will have to tell you if you're going to borrow money, they're going to have to tell you if they're going to be borrowing money from you, from you, they're going to have to tell you how much they are willing to pay you. So simply put this bond, every six months, this is how we compute the interest payment in cash. Let's not call it the interest. Let's call it the cash payment. We're going to take the face value, which is 100,000, multiplied by the stated rate, 8%, multiplied by 1 half. Now why did I multiply by 1 half? 1 half, it means you make it 4%. The reason is because the interest is paid semi-annually. It's the nature of the bond. If the bond pays interest annually, then multiply it by 8%. And this will be the cash payment. Now why is the bond called the coupon? Why is this rate, why is the stated rate sometimes called the coupon rate? Well, the coupon, I hope you are familiar with coupons. Coupons, as you can clip. Back in the old days, when you had a bond, okay, when you had a bond, you'll buy this piece of paper with those coupons attached to it. And every six months, you will detach a coupon. You will detach the coupon and you will submit it to the company for payment. You detach the coupon, you detach the coupon, and with the last payment, you want to get back your 100,000. And that's why it's called coupon rate, because it looks like a coupon for that matter. Now how do we compute the interest expense? Now we computed the cash payment. Well, take this formula down for now, and we're going to learn about the interest expense later. But write it down. The interest expense is the market rate, which is something totally different. Notice we had so many different rates here. None of it is the market rate. So this is something new. The market rate times the carrying value. Hold on a second. We never mentioned the carrying value. Don't worry about this. The point I am trying to make is, the cash payment might be different versus the interest payment might be different. And oftentimes it's different than the interest expense. Don't worry, we will see why shortly. And notice it's totally different numbers. Here you are using the face value to get to the cash payment. Here you are using the carrying value. Two different computation, totally different. And this is what tricks students. Now what is the market rate or the yield rate? Sometimes the market rate is called the yield rate. Like if we don't need additional terminology in this chapter, right? It's often different than the stated rate. Okay, so the market rate and the stated rate are totally different. So hold on a second. You already told me what the market stated rate is. How much the company is paying? What about the market rate? Just hold on on the next slide. I will explain what the market rate is. Just know that there's a market rate for now. Now to find the price of the bond, also write this formula down. Since the bond is composed of two parts, what are the two parts? Well, remember what I showed you. You will get payments. Let me change colors here. Maybe I will get a different color. Maybe I will highlight. You will get the payments on the bond. That's one sort of revenue. You'll get the payments. You'll get the payments on the bond, the future payments, plus you will get the face value. So the bond is composed of two parts, the face value and the future payments. And what happened is when you are buying the bond, hopefully you remember from the discounted chapter, from the chapter where we discuss the time value of money, you have to discount them. You have to find the present value of those two. And those two together will give you the bond price. Don't worry, we're going to work two examples, at least about this. So we've been talking about the market rate a lot. So what is the market rate? Well, we need to define what a market rate is, because that's going to make our life easier. Well, what's the market rate? Well, let's talk about the stated rate one more time. The stated rate for the sake of our illustration is 8%. This is what the company is willing to pay if you buy their bonds. That's fine. Now, creditors, investors, lenders, they're going to look at your rate and they're going to think about their alternative. They're going to think, OK, why should I give you my 100,000 when I can go somewhere else for the same risk? Someone else is paying 10%. What does it mean 10%? It means someone the same size of your company, the same credit risk. Credit risk means in the bond terminology, there are credit risk. For example, a company could have triple A credit risk, double A credit risk, A credit risk, triple B, double B, B, so on and so forth. The highest credit rating is triple A. So if you have triple A, it means you have a good credit rating, you pay lower risk. But let's assume a company similar to yours, let's assume you're double A, you're paying A, they're paying 10%. Well, guess what? No creditor in the right mind that's going to give you the amount of money that you need to get paid 8%. If they go to the market and they can get 10%. So if they decided to buy your bond, if they decided to buy your bond, what's going to happen is they're going to buy it at a discount. What does discount mean? It means they are going to pay you less than the face value. Don't worry, again, we'll do a computation. But the point I want you to understand the business mechanics behind it. If someone is paying 10% and you're paying 8%, and those two companies are comparable, you're going to go and give your money to the person with 10%. If you're going to go with the 8%, you're going to give them less money. Don't worry, we'll compute that. If you're paying 8%, the market, everybody else similar to you is paying 8%. Your bond will sell at par. At par means at face value. You'll get exactly what's written on the amount on the face of the bond. You're paying 8%, everybody's paying 8%. Whether they go to you or they go somewhere else, it's the same. Let's assume you are paying 8% and the market is paying 6%. Now you are paying more than the market. What's going to happen is everyone wants to buy your bond. Your bond will sell at a premium. It means above the face value. Now this is how bonds are quoted in the real world. For example, this is Texas Instrument. They mature at 1231, 2040. There is 500 million bonds. The price is quoted as a percentage of par. This price is 120.6%. What does that mean? It means if you want to buy this one bond today, you multiply it by 1.206 to get to the price. It means this bond is $1,206. This bond is trading at a premium. Why? Because it's more than 100%. If we look at the Lenovo bond, we have 1,000 of them, they're trading at 94.3%. It means if you want to buy this bond today, you would only have to pay $943. This bond is traded at a discount. Deer Park, which is that's unusual. Well, I meant to say 2032. Deer Park, they have 200 bonds and they're traded at 100%, that means they are traded exactly at face value. If you want to buy them, you'll get 1,000. Sell them, a bond sells at par value. Now also the bond, when you are looking at bonds, they will show you the coupon rate. So Texas Instrument is paying 7. Lenovo is paying 3. Deer Park is paying 5. This is basically, remember, the coupon rate, the stated rate. So when you're looking at bonds, they will have to show you the coupon rate as well. So this is just for illustration purposes. I made up these numbers. Now the best way to look at these examples, look at everything that we learned, is to look at a comprehensive example where we compute the price of the bond, whether it's a premium or a discount, learn exactly how we came up with this number, then do the journal entries and see what happened when we make those interest payments. Before we look at an example, once again, I would like to remind you, whether you are a student or a CPA candidate, you take a look at my website, farhatlectures.com. If you are a CPA candidate, I don't replace your CPA review course. You can keep it. It's a great resource for you, nor I replace your accounting courses. I am a useful addition. I explain the material differently. I provide you with additional resources, exercises, multiple choice, that's going to help you do better. Your risk is one month of subscription. Your investment in your accounting and CPA is important. Don't shortchange yourself. Take a risk for one month. You like it. You feel it's helping you. You keep it. You don't, you cancel. It's not the end of the world. However, you are given yourself a chance to succeed. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all the accounting courses that I offer, including advanced accounting, taxation, governmental, so on and so forth, auditing, intermediate accounting. My CPA supplemental resources are aligned with your Becker, Roger, Gleam, or Wiley. So it's very easy to go back and forth between my material and your CPA review course. I offer 1500 plus in addition to all my multiple choice questions. Previously, AI CPA previously released questions with detailed solution. Please connect with me on LinkedIn. If you haven't done so, like this recording, share it with other connect with me on Instagram, Facebook, Twitter, and Reddit. Let's take a look at this example to illustrate everything that we have talked about thus far. On January 1st, 20X1 Adam company issues. Issues mean sell $100,000 in bonds due in two years, the two year bond with 8% interest payable semi-annually. At that time, the market rate for such bond is 10%. Let me show you first what we are looking at. Whoever buys the bond will get $100,000. And we'll get four payments. Why four payments? It's two year, but it's paying interest semi-annually. And how much is the payment? The payment will be always $4,000. $4,000, $4,000, $4,000, and $4,000. And with the last payment, you'll get back your $100,000, the face value of the bond. Now whoever is going to buy this bond, they're going to look at the market and say, well, before I give my money to Adam, what is the market paying? Because if Adam is not paying something in comparison with the market, I'm not interested in buying his bond. Well, what is Adam paying? Well, Adam is paying for his bond 8%. And the market rate is 10%. What does that mean? Automatically, you would know that this bond will sell at a discount. Now how do we compute the price of this bond? Well, here's what's going to happen. First, we're going to discount the face value. So this face value we're going to discounted to the present value. Well, we're going to get the $100,000 only one time as a single amount. Therefore, we're going to take the $100,000 and every time we go to the tables, you want to earn the market rate. I'm going to repeat myself. When you go to the tables, you always use the market rate. The market rate is what investors want to earn under investment, not the stated rate. The stated rate is what the company is offering you you want to earn the market rate. When you go to the market rate, because this bond is semi-annually, rather than using 10, you're going to be using 5%. And rather than two years, this bond is a four year, because it's a four year bond. It's a four year period, because it's a two year bond. And if we go across and we find out that they cross at this present value, single amount present value factor. So what's going to happen? We're going to take $100,000 and discount at 0.82270. And that's going to give us $82,770. So this is the value of this $100,000 separately. Are we done yet? Absolutely not. Also we have to discount, also we have to discount the $4,000. Do you remember the $4,000? One, two, three, four of them. We have to discount them, but now the $4,000 are in annuity, because they happen to be paid at the same interval. Well, we're going to go to the annuity table, four payments. We're going to discount them at 5%. And the factor is 3.54595. So the payments are worth $14,183.8. Together, the bond is valued at, or the issue price of the bond is $96,453.8. Now we can say it's 96.453% as the price, as if you want to quote it as a percentage. But we know this bond sold at a discount. Well, what do we do next? We are going to start the journal entry. The company would receive in cash, the company would receive in cash $96,453.80. They are responsible for paying back $100,000, because the bond face value is $100,000. The difference is a discount. The difference is a debit of $3,546.20. So now what we need to do is we need to know, we need to know what are we going to do with this discount? Well, what we do first and what companies do all the time is they prepare what's called an amortization schedule for the discount. What does that mean? Well, for any bond, the company will determine what's the carrying value. Don't worry, we'll come back to the carrying value in a moment. Basically, the carrying value is the face value. If it's a discount bond, it's a face value minus any an amortized premium. So when we issued the bond, we had $3,460.20. Therefore, the bond carrying value is $96,453.80 when we issued the bond. Now, six months later on July 1st, we're going to be making our first interest payment. The cash will always be the same, $4,000. This is how much cash we have to pay. How do we find out the interest expense? Do you remember when I said write this formula down, it's the bond carrying value or the bond book value, the bond book value times the market rate? Well, the bond book value at the beginning of the period was $96,453. If we take this number, $96,453 times 5% because it's the market rate semi-annually, we're going to get $4,822.69. And this is the interest expense. So we figure out our interest expense. We already know how to figure out the cash paid. The difference between interest expense and the cash paid is the amount we are going to amortize. So let's take a look at the journal entry first. The cash is $4,000. First, the cash is easy. It's going to be the same. Notice the cash paid is the same. The interest expense is the carrying value times the market rate. If it happens to be semi-annually, make sure you divide the market rate by two. And the difference between them is how much we are going to amortize. So here's what's happening now. If we have a discount, the discount started, our discount started at $3,546.20. Now we credited the discount $822.69. As we credited the discount, as the discount goes down, remember, we had 100,000 book value initially minus the discount of $3,546.20. And initially, our carrying value was $96,453.80. What did we do six months later? We reduced the discount. We credited the discount. We reduced the discount. What's going to happen? As we reduced the discount, as we reduced the minus, the book value goes up by the same amount. So notice what happened. By July 31st, we added to the previous book value. We took $96,453.00 and added the amount of discount that we amortized. Now our book value went up to $97,276.00. Six months later, on December 31st, again, we're going to take our new book value, $96,276.00, $97,276.49 times 5%, and that's going to give us our interest expense. The cash amount is the same always, $4,000. The difference between them is the amount we're going to amortize. And if you know how to do the first two journal entries, then you know how to do the rest, whether the bond is two years or 10 years or 20 years. Now what happened? Again, the bond carrying value go up. Let me make some observation you want to be very familiar with before we leave this slide. This is a discounted bond. Notice the first thing I want you to notice, the bond carrying value or the bond book value, bond carrying value or book value are the same, is increasing. It went from $96,453.00 to $97,276.00 to $98,140.00. I know I'm going down, but it's going up. That's the first thing I want you to notice. As a result, if the bond book value is increasing, interest expense should be increasing. Why? Because the interest expense is book value times the market rate. Well, if your book value going up, your interest expense will go up. So hopefully this makes sense. Three, interest expense is higher than your cash payment. Why? Why? And notice that your interest expense, $4,822.00 is higher than $4,000.00. Your interest expense, $4,863.00 is higher than your cash. Why? Because initially, when you sold this bond, you sold it at a discount. And what is discount? Discount is future interest. Future interest. Discount is a contra liability. So what happened? Now you are amortizing the discount to interest expense. Therefore, your interest expense will be higher because it's going to be amortized to interest expense. Three, if you notice, if we go through the two years, the amount of the discount is fully amortized. Now there's a rounding $35.46.9 versus $35.46.20. It's a rounding error. Then also what I want you to notice is the bond is back to the face value. Again, this is also a $0.30 rounding error, but the bond will always go back to the face value once it matures. Very important concept to note that if you wait until the bond matures, it will always go back to its face value, whether it's a premium or a discount because you will amortize the premium and you amortize the discount. So make sure you take a note of this observation. I'm going to show them at the end as well. Now let's change the scenario a little bit. Let's assume the same bond, $100,000 bond, paying 8% interest. The market rate is paying 6%. Now, Adam is paying more than the market. What does that mean? It means Adam will get more for the bond. Let's see the computation of the bond now. Well, Adam is paying $4,000 per month. That's the annuity. What does that mean? Well, it means if we take the present value of the bond, now we're going to go and discount it at 3%. So 4 period, 3%. We're going to multiply it by 0.8849 and the amount, the face value is worth $88,849. Now we're going to do the same thing with the $4,000 with the annuity. Four payments at 3%. The factor is 3.71710. Well, that's going to give us a bond price of 103.707 or 100.0371%, 717%. It's a premium bond. Well, how much is the premium? The premium is $3,717. Well, remember, in the prior example, we had a discount, we received less. The premium is we received more. The premium is an adjunct liability. Remember, the discount was a contra-liability. Now the premium, if we take the face value of the bond, if we take the face value of the bond plus any an amortized premium, 717, that's going to give us the bond book value. So the bond book value or carrying value is the face value plus any an amortized premium. Let's do the journal entry. Cash 103.717.40. We are responsible for paying 100,000 at the end. And now we have a premium to amortize 3717.4. Let me tell you something about the premium. Think of it as the opposite of discount. The discount was amortized to interest expense, which increase interest expense. The premium, it's going to be amortized against interest expense. It's going to reduce our interest expense. The best way is to take a look at it. Again, we're going to prepare this amortization schedule, starting with the bond carrying value of 103.717.40. Six months later, we're going to make our first cash payment 40,000. Now, how do we compute our interest expense? We're going to take 103.717.40 times 3%, and that's going to give us 3,111.52. That's our interest expense. The difference between what we paid and the interest expense is the amount that we amortized, and this will be our journal entry. Credit cash, debit interest expense, debit premium. Now, as we amortize the premium, as the premium goes down, the book value also goes down, because it's face value minus the end amortized premium. As you're taken away from the premium, your book value is going to go down. So notice your second payment. After you make your second payment, $4,000, your interest expense is $102,828.92 times 3%. The difference between what you paid and the interest expense is your premium. Again, it's going down. Your premium is going to bring down your book value as well. So very important observation to see, very important observation to see. So the book value is decreasing because we started above the part, above the face value. Interest expense is decreasing. Of course, if your book value is decreasing, your interest expense is a function of your book value. As the book value goes down, your interest expense goes down. Premium is fully amortized. Now again, we're talking rounding error. Interest expense is lower than your cash. Sure it will be lower than my cash, because I received more money upfront. And bond is back to the face value. There is again, 30 pennies rounding error. And this is important to be able to observe and be able to see this, because you can answer many questions on the CPA exam by looking at this. Let me show you both the discount and the premium bond side by side so you understand what we are looking at. In a discount bond, the book value or the carrying value will go up. In a premium bond, the book value or the carrying value will go down. Interest expense will go up period after period because your book value is going up. Your interest expense will go down because your book value going down. Interest expense is higher than your cash. Makes sense because you received less money upfront. Interest expense is lower than your cash payment. That makes sense. You received more cash upfront. Discount is fully amortized. Premium is fully amortized. So if you wait until the bond, everything should be amortized. Bond is back to the face value. Bond is back to the face value. Remember, we had 30 cent rounding error. And the most important thing before I leave you is how we compute the carrying value of the bond. If it's a discount bond, we'll take the face value minus any unamortized. It hasn't been amortized. If it's a premium bond, we're going to take the face value plus any unamortized premium. It's going to give us the carrying value. Now, why am I emphasizing the carrying value a lot? Well, the reason I'm emphasizing this point a lot because in the next session, we might buy the bond before it goes back to the face value, before it matures. Well, why is that important? Well, because when you buy it, you have to take a look at your carrying value to determine whether you have a gain or a loss. Now, the best way to learn this more is to go to my website, work multiple choice questions, additional questions, view additional exercises to help you understand. At the end of this recording, I'm going to remind you again, whether you are a student or a CPA candidate, take a look at my website, farhatlectures.com. I don't replace your CPA review course, nor your accounting course. Invest in yourself, invest in your career. I can help you do better. And that's the point. Your investment in your education is a lifetime investment. It's going to pay you dividend forever. Don't shortchange yourself. Good luck, study hard, and of course, stay safe.