 session. This is Professor Farhad and this session would look introduction to bonds, would look at bonds issued at bar, discount and premium. This topic is covered in financial accounting, as well as intermediate accounting. If you don't feel that this explanation went in depth as much as you would like to, please check out my intermediate accounting explanation for the bonds. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, tax and finance lectures. This is a list of all the courses that I cover, including many CPA questions. If you like my lectures, please like them, share them, put them in playlists, subscribe, let the world know about them, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to help you study for the CPA exam and supplement your accounting education. So what is a bond and what would the bond looks like? So this is a bond. A bond is technically a piece of paper. So let's go over the bond here because it's, I want you to see the bond. I want you to see the bond. I want you to touch the bond. So it'll be easier for me to explain this. So a bond is a piece of paper that the company issue. Issue means we're going to be using this term a lot in this session. Issue means sell. Issue. So when we say issue, it means they sold it. They released it. They issued it. They issue to lenders. So you, McDonald, issue this McDonald's corporation, this is the issuer company, issue the bond to lenders. Who are the lenders? Lenders are people who are willing to, who are willing to lend money. So what pictures are we looking at here? Here, McDonald's is issuing a $100,000 bond to raise money, $100,000 bond. So this is the amount that they're trying to raise, $100,000. So the par value, the dollar amount is listed on the bond. Notice it's $100,000. We call it par value. Now this bond represent 100 bonds. How did I know it represent 100 bond? Because each bond is $1,000. So if each bond is 1,000, and the full amount is 100,000, it means we have 100 bonds. So what we're looking at here is a bond is a piece of paper that represents 100 bonds. That piece of paper could represent one bond, two bonds or 100 bonds. So it represents 100 bonds. The stated rate is another component of the bond, the state rate or the contract rate. Sometimes it's called the stated rate. Sometimes it's called the contract. Sometimes it's called the coupon rate as well. So there are many names for it. Contract, coupon, stated. What does that mean? It means if you give McDonald $100,000, McDonald will give you 8%, 8%. What does that mean? It means they're going to pay you 8%. However, the interest, it's going to be paid twice a year. So they're going to pay you 4%, then another 4%. So simply put, one important computation is this. How much cash you will get by owning this bond, by buying this bond? It's a $100,000 bond. We'll take the par value, copy this formula down, times the stated rate, 8%, times 1 half. Now, why did I say 1 half? Because notice this bond pays interest summa annually, 1 half. So rather than $8,000, 1 payment, you're going to get 2 payments of $4,000. So every 6 months, June 30th you will get 4,000. December 31st you'll get 4,000. So I'm just breaking down the component of the bond. So you have the par value. The par value is also called, let me just tell you, it's called the maturity value. And this is an important concept to understand in bonds. Maturity means that's the amount that you will get when the bond mature. When does the bond mature? There's a maturity date. Here's the maturity date, December 31st, 2021. It means on December 31st, 2021, you can take this piece of paper back to McDonald if you have it, if it's in your name and ask them for your $100,000. They will only pay you $100,000. Because what's printed on this bond? $100,000. What's printed is the par value, is the par value of the bond. You can only get back $100,000. And this is an important concept and you will see why I'm emphasizing this point. Because when you buy this bond, you will see shortly that you could pay more than $100,000 or less than $100,000. But you will get only $100,000 when you present that bond at maturity. So those are the basic pieces of a bond. So it's very important to understand them. Let's put them here in another way to look at them. So bond is a form of financing. If McDonald wants to raise money, they can issue bond. They can sell bonds and get money in return. So the corporation, MCD is the corporation, they will issue bonds to lenders. And the lenders will give them back the $100,000. We're going to assume they're going to give them back exactly $100,000. Then McDonald will have to pay the lenders $4,000 every six months. $4,000 every six months. So to compute the interest payment, we'll take the bond par value, which we talked about this, which is $100,000 times the contract rate or the stated rate. Remember the contract rate, the stated rate, the coupon rate, which happens to be 8%, what McDonald is offering times the time since they pay interest semi-annually. We're going to multiply this by half. So every six months McDonald will pay the holder of this $100,000 bond, $4,000. So those are the basic components of a bond. And we're going to look at them again one more time in a moment. Bond are traded. Now, once the company issue a bond, once the company issue a bond, the bond is traded just like stocks. It's, you can, you can sell it or you can buy bond, so on and so forth. So let's see how bond are priced because that's an important thing for us. This is a bond for IBM. IBM is the bond. The rate is 4%. What is the rate? This is the stated rate or the contract rate. It means this bond pays 4% per year or if it's semi-annually, 2% semi-annually. The maturity is 42. What does 42 mean? It means it mature in year 2042. It means it mature in year 2042. Don't worry about the yield now because you won't be able to understand what the yield means until you have further understanding of this. The volume is 110 or is 110 bonds traded. The price, this is important. So this is important. So of this slide, if you want to get anything, is the price of the bond. The price of the bond is expressed as a percentage of their power value. So if we're dealing with that bond that I showed you earlier, the power value is 100,000. If I take the power value, multiply it by 103.08%, 103 times 08%. That's the price. That's the price of the bond. It means you have to pay 103,080 dollars. This is the price of the bond. We call this price of the bond premium. Don't worry about this. We're going to explain why it sells more than 100% shortly, but it's very important to understand the pricing of the bond. So if this bond is selling at 100%, it means you have to pay $100,000. If this bond is selling at 95%, it means you pay $95,000 for this bond. So the price of the bond could be a premium above 100, exactly 100 or below 100. If it's above 100, we call it a premium. If it's exactly 100, we call it par. If it's below 100, we call it a discount. Hold on that. We're going to discuss why bond trade at those prices. So bond are securities just basically like stocks that can be purchased or sold in the securities market, basically Wall Street. They have a market to which is expressed as a percentage, as a percentage times the par. The closing price indicated that the IBM stock or the IBM bond, not stock, is being sold at 103.08% of face value, which is I told you the amount if you want to buy it. Now, don't worry about why it sells at a premium. We'll talk about this. Now, what we need to worry about is how to issue a bond. When a company issue a bond, and we're going to be dealing with this bond. So let's look at the component of the bond. What are the components? On December 31st, 2019, McDonald issue the following bond. So we're dealing with this bond here. Par value of 100,000. It means if you buy this bond, we're going to give you back 100,000 when it matures. The contract rate or the stated rate is 8%. This is how much McDonald is willing to pay you. And we're going to pay you that semi-annually. It means June 30th and December 31st. So every six months, we'll pay you 4% in a total of 8%. And the bond matures December 31st, 2021. And that's two years from now. So you buy this bond, you're going to get four interest payments because we pay interest twice a year. Then you'll get your money back. First, let's issue the bond. And let's assume this bond sells at par. Now, don't worry why. We're going to explain why later. So the company will debit cash on December 31st, 2019, McDonald, and they will credit bonds payable 100,000. They recorded a liability of 100,000. Now fast forward six months. Six months later, McDonald will have to pay the first interest payment. On June 30th, 2020, the issuer of the bond makes the first semi-annual interest payment of how much? 4,000, which is the par value times the stated rate times one half. So McDonald will debit bond interest expense, 4,000. They will credit cash 4,000. And here's the computation of the cash amount. So this entry is made for six months until the bond matures, until the bond matures. Now, when the bond matures, it matures two years later. On December 31st, 2021, the bond matures and the issuer of the bond pays the face value. You only pay. Listen to me carefully. Listen to me carefully. When the bond matures, when the company, when the bond matures, they only have to pay the face value if they wait until maturity. And what's the face value? What was written on that bond 100,000? Therefore, we debit the bonds payable to get it out of the books and we pay the lender 100,000. So simply put, this bond is now paid. We paid it. How much do we pay? We pay 100,000. We pay 100,000. Now, let's talk about when a bond is sells at a discount or premium. The bond that we looked at was selling at par. It means it means McDonald wanted 100,000 and they got exactly 100,000. It's at par. Now, let's explain the concept of a premium or a discount. Now, remember McDonald had a contract rate or a stated rate and McDonald says, I'm willing to pay 8%. If you don't believe me, look, McDonald says this is my stated rate. Notice it's printed on the bond. It's printed. That 8% is printed. It does not change. Once they say they're going to pay 8%, they're going to pay 8% until the bond matures. So let's assume, let's not assume, let's assume when we're working with this bond, 8%. Now, we're going to look at another rate. Now, this is important for you to understand. So we have bond sets. So McDonald sets the rate at 8%. Then there is the market. What is the market? The market is all the other bonds that are similar to McDonald's. So when McDonald's sets this bond at 8%, if you are a capital provider, if you are a banker, if you are an investor and you're interested in buying this bond, you ask yourself, McDonald is paying 8%. Let me take a look at the market. What is the market paying? Is McDonald paying as much as the market? If the answer is yes, let's assume that's the case. Let's assume the market rate, everybody that's similar to McDonald is paying 8% and McDonald is paying 8%. So McDonald is paying 8% and McDonald is paying exactly what everyone is paying. So they're paying 8%. So the contract rate is 8% and everyone else is paying 8%. Well, if that's the case, if I'm an investor, whether I give my money to McDonald or I give my money to somebody else in the market, if they're all paying 8%, I'm willing to only pay 100,000. So when your contract rate, when McDonald is offering 8% and everybody else similar to McDonald, we call it the market, is offering 8%, the bond sells at par. And this is what we looked at when we did the transaction a minute ago. We assume that the bond sells for 100,000. Let me give you another scenario. Now, let's assume the contract rates, we can change this 8%. And let's assume the market rate, the market rate is 10%. And you have money to invest. So we're done with the par value. Let's take a look at the second scenario. So McDonald, MCD is offering 8%. That's all what they can afford to pay, 4% every six months. But similar companies to MCD like Burger King, like Wendy's, they're paying 10%. Well, guess what's going to happen? No investor in the right mind, they will pay McDonald $100,000. Why? Why wouldn't they pay them 100,000? Because if they do have 100,000, rather than giving it to McDonald and earn 8%, I can give it to someone else and earn 10%. So what happened to McDonald under those circumstances? McDonald will have to lower their price of the bond. So McDonald will have to accept something less than $100,000. Under those circumstances, we say the bond sells at a discount. So McDonald will have to accept 98%, or 97%, or 99%. Something below the price of the bond. Now, we're going to learn how to compute exactly the price of the bond later, or there's a way to compute this. But the point is you have to understand if your contract rate, if what you are offering is less than the market, then you're not going to be able to get your par value. No one in the right mind will pay you the full 100,000 if they can take their full 100,000 and buy another bond that pays them 10%. Now, let's work another scenario. Let's assume we're still dealing with the same bond. McDonald is paying 8, and everybody else in the market is paying 6. McDonald is paying 8, and everybody else is paying 6, similar to McDonald. Guess what's going to happen? McDonald will have a flood of investors, flood of people who are interested in buying their bond. Well, guess what? McDonald, they're not stupid. They know that's the case. Guess what they do? They will sell their bond at a premium. The price of the bond sells at a premium. It means the bond will sell at 103%, 104%, 101%. It's above 100. Why? Because McDonald is offering something that's very attractive. And why is it attractive? Because it's higher than the market, than the bond sells at a premium. So it's very important to understand when the bond sells at par. Well, the bond sells at par when McDonald offers 8, and everybody else similar to McDonald's offer 8. Well, whether I go to McDonald or somewhere else, I'm going to get the same bond. It sells at par and par means 100%. Now, let's take a look at an example of how do we deal with a bond issued at a discount. So we're going to look at Fila issues the bond with the following provisions. Par value of 100,000. Issue price 96.4. Now, all you have to know now is this is a discount bond. This is all you have to know. Now, how do we come up with this figure? That's a different story. The stated rate is 8. Now, you know that if they're offering 8, the market must be offering more. The market is 10. Well, the bond will sell at it, the bond now, the bond will sell at a discount. Why? Because the market is offering more than Fila or more than McDonald. They pay interest on June 30th and December 31st. They issue the bond December 31st 2019 and the bond mature December 31st 2021. Now, we're going to look at the issuance of the bond. We're going to issue the bond and see the journal entries for a discount bond, for a discount bond. So let's take a look first at when we issue the bond. So on December 31st, we issue the bond. How much are we going to get for this bond? We're going to get 96.4. So if we take 100,000 times 96.4, we are going to get only 96,400 in cash. Although what's printed on the bond is 100,000. So the difference between the par value, 100,000 and how much cash we received is called a discount. So this amount is the discount. Now, let's look at the journal entry. So we debit cash only 96,400. This is how much cash we received. We credit the bond 100,000. Why do we credit the bond 100,000? Remember, whoever carries the bond, the bond has printed on it $100,000. So think of the MCD bond, McDonald bond. Remember, what's printed on it is 100,000. So when somebody comes back in two years, it doesn't matter what we get initially for the bond. What matters is what's printed on that bond and we'll pay them for, we pay them that amount. Therefore, our obligation is 100,000. That's very important. Students, they don't understand this concept. It's very important to remember. Now, the difference we said it's 3,600 and we call this a discount on bonds payable. So we have a new account called discount on bond payable. Discount on bond payable is a contra liability. What does that mean? It means it reduces the bond. So if the bond is 100,000, and we're going to now learn an important concept, contra is reduces minus any discount that has not been amortized because we are going to amortize it. So if we take 100,000 minus 3,600, we get how much? We get 96,400. So the bond face value or well, let's use the term par value, but face value and par value are the same. Par value minus minus any un amortized. It has not been amortized. We did not expense it yet and amortize discount. So this is an important computation gives us the carrying. We call it carrying or book value. I'm going to call it carrying because that's the term that they use. We call this carrying value of the bond. And this is going to become an important computation in the next session. So 100,000 minus the bond discount that gives you the carrying value of the bond. Let me show you how things would look like. This is the carrying value of the bond that's on the balance sheet. Now the question is what do we do with this 3,600? That's the question. And what does this discount represent? Let's think about it for a moment. What does this discount represent? Really, this discount represent interest. Why? Because we tried to borrow 100,000. We were not competitive. We were not competitive. We could not offer an interest that's going to attract the investors because our interest rate was eight. Everybody else was paying 10. Therefore, we lost upfront 3,600. We could not get that money. Well, this is basically part of our finance and cost. It's part of our interest. But here's what we do. So this is basically the 3,600. Think of it as kind of a prepaid interest. It's not prepaid interest, but think of it as interest that we paid upfront. Why? Because we didn't get the money. So what do we do with interest? We are going to amortize the interest. In other words, we are going to take this 3,600 and we are going to spread it over the payments that we're going to be making. If we divide by four payments, now why four payments? Because this is a two-year bond and we're going to have four payments. If you take 3,600 divided by four, we are going to amortize two expense. Listen to me carefully. We're going to amortize two expense. So I'm going to write it up here. Amortize two expense and specifically to interest expense. Amortize to interest expense $900. So when we make our first payment, so focus with me on this journal entry right here, when we make our first payment, we are going to credit cash $4,000, which is the same, the same that we did for the par value bond. Par value times one-half times the contract rate. This does not change. This does not change because we promise to pay 8% or 4% semi-annually. It's going to be 4,000. Now we are going to amortize $900. Remember, we had this discount account. We have this discount. We have this discount. And in this discount, we had 3,600. And what we did now, after six months, we're going to amortize, we're going to debit it 900. And by debiting 900, we have to credit something else. We credit interest expense because now we are counting this interest expense. We are, we credit this amount. I'm sorry, it's one second. I made a mistake here. The discount is a debit balance. So give me one moment. Sorry. So the discount is 3,600. And we are going to amortize 900. So we credit the amount 900. We credit the discount 900. And we debit interest expense. So we credit the discount 900. In this 900, we add it to the interest expense. Therefore, the entry would look something like this. Credit cash, 4,000. This is how much cash you paid the check that you wrote. However, your interest expense is 4,000 plus 900. Why plus 900? Because you have to amortize this 3,600. And how did you amortize this meaning taking the cost and spreading the cost equally over the payment using the straight line method? Now that's not the only method. There is the straight line method and there is the effective interest rate method. If you're interested in the effective interest rate method, go to my intermediate accounting course. I don't cover it in my financial accounting. I cover it in my intermediate accounting. Now, if I ask you how much what's the total interest expense for this fund? What is the total interest expense? Here's what's going to happen. We're going to have four payments of $4,000, which is 1,000 times 8% times 1 half. And the company will have to make this payment four times. So 4,000 times 4 is 16,000. Plus, up front we lost 3,600 because of the discount. So the total interest expense is 19,600. Now, if we take 19,600 divided by 4 payment, our interest expense is 4,900, which is the same thing as I told you earlier. It's the cash payment plus the bond that you amortized plus the bond that you amortized. So it's very important to know this. Now, when we have a discount bond, the discount bond is below the par value. So the carrying value started at 96,400. Notice here, when we started this bond, the carrying value was 96,400. And the amortized amount was 3,600 because this is how much amortized amount we have. So let me show you in a T account how it looks like. So we have the discount here. And in the discount we had 3,600 initially. Then after one payment, we reduced the discount by 900. We reduced the discount by 900. Now, the carrying value goes up because now what we have is we have a $100,000 face value minus 2,700, which will give us 97,300. So the bond value goes up. Another six months later, we will reduce the discount again. As we reduce the discount, as we reduce the discount, the carrying value goes up again by 900. Then we reduce the discount again by 900, when we make the third payment and the fourth payment, as we make the payment, the bond value goes up. It keeps going up until it reaches the maturity value. So always the bond goes back to its maturity value. So if it's below the maturity value, if we wait and we amortize all the discount, as we did here, eventually the discount will go down to zero. The discount will go down to zero. Notice. And the bond becomes at power value. The power value is $100,000. So this is the life of a discounted bond. Let's take a look at a premium bond. Summon we're looking at an Adidas issued a bond for $100,000. The issue price is $103,600. You are giving the price. You don't have to compute the price. What does that mean? It means the stated rate was 12% for this example. So what does that mean? It means the market rate has to be lower. The market rate is 10. Because the stated rate is higher than the market rate, the bond is issued at a premium, which is $103,600. This bond pays interest semi-annually. Bond issued at December 31st. The maturity date is in two years, December 31st, 2021. Now we're going to do the same thing with the premium bond. With the premium bond, we're going to issue the bond at 100 times 103.06. And the cash amount is 103,600. So actually we received more than 100,000. Why? Because everybody wanted to buy our bond. As a result, we got more than what we thought we will get. We got more than 100,000. Now we paid the price for that. What's the price that we paid? Well, we are offering higher interest rate. It means we have to make more cash payment. So simply put, the difference between the par value and the cash proceeds, it's called the premium. The premium is $3,600. But now it's a premium. Now let's look at the journal entry. Cash we received 103,600. We always credit the bond for the par value. That's bond, par value is 100,000. The difference between the two, now it's called a premium. What type of account is the premium? The premium is an adjunct liability. So what are we going to do with this adjunct liability? We're going to amortize. We're going to spread. We're going to amortize. Look, against interest expense, we're going to amortize against interest expense, against interest expense, not to interest expense. It's going to reduce our interest expense. Why is it going to reduce our interest expense in contrast to the discount? The discount, we amortize the two interest expense. So every time we amortize that we increase our interest expense. Now the premium, every time we amortize this 3,600, every time we amortize a part of it, it's going to reduce our interest expense. And when do we amortize it? Over the life of the bond, over the life of the payment. The same concept now with the bond carrying value. The bond plus, notice plus, any premium gives you the carrying value. So this is the carrying value of the bond. The carrying value of the bond is the bond, which is the power value plus the premium. If it was a discount, minus the discount, plus the premium. So this is the bond carrying value. So when we issue the bond, we debit that cash 103,600. Again, we credit the bond payable exactly for the, for the, for the power value and the difference is a premium. Now let's make our first interest payment. Well, our first interest payment, let's focus with me right here. First interest payment, this blocks here. The first interest payment, first is the cash. It's 100,000 power value times 12% times one half. And that's going to give us $6,000. So we have to write a check for $6,000. We credit cash $6,000. Now what we do, we have to amortize some of the premium. We have 3,600 divided by four. So every time we are going to, every time we make an interest payment, we're going to use 900 of the premium. Therefore, we're going to debit 900 of the premium. Remember, the premium is a credit account. Remember, the premium is an adjunct liability. Adjunct means it's like a liability, but it serves another liability. The premium is 3,600. Now what I'm going to do, I'm going to debit this premium 900 when I make my first interest payment. And as I debit the premium, I credit my interest expense. So I debit the premium and I credit, I reduce my interest expense. So I debit the premium. I debit the premium and I credit interest expense. So notice, I debit the premium. And rather than debiting 6,000 of interest expense, I only debit 5,100. Why 5,100? I paid 6,000 minus the premium that I received. So my interest expense is 5,100. Notice the interest expense is lower than the cash. Why? Because I got the money upfront. And this entry would repeat itself four times. So every time I make a payment and as it repeats itself four times, I will bring down the premium down to zero. So I'll get rid of the premium once the bond mature. Now if I ask you, what is the total interest expense on this bond? Well, we pay $6,000 every four months, every six months, we make four payment. That's 24,000. Then we received 3,600 more for the bond. So we reduce our interest expense by the extra money. So our interest expense is 20,400. If we divide 20,400 by four payments, our interest expense should be 5,100, which is the same computation that I showed you here. It's the cash minus any discount, any discount that I have not, minus any discount, minus any discount. Now this is the computation for the cash payment for this, how we come up with the 6,000. I already did this for you. Now the last thing is just like with the bond discount, we have a premium bond amortization. The carrying value when we issued the bond on 1231, 2019 was 103,600 and the bond and amortized premium was 3,600. So if we take 100,000 plus 3,600, that's what gave us 103,600. But six months later, we reduce the premium. As we reduce the premium now, the carrying value goes down because this goes down, the carrying value goes down. Then we reduce the premium again by 900, the carrying value goes down. We reduce the premium, the carrying value goes down. And once the premium goes down to zero, the bond goes back to its par value, just like with the discount bond. So always the bond, once it's properly amortized, whether it's a premium or a discount, if we wait till the end of its life, the bond goes back to its par value. Notice the bond went back to its par value. So it was above par value, and it went down to par value by amortizing the premium. For the discount bond, let's go back to the discount bond, the discount bond, let's go back to the table, the discount bond, the bond was below the par value, it went up to the par. It was below, and it kept going up. As we amortize, it goes up until it goes back to the par value. So that's why if the bond mature, it will go back to its par value. Now, if you like this recording, please click on the like button, share it, subscribe. In the next session, we would look at bond retirement. What is bond retirement? Bond retirement is when we buy back the bond. As always, I would like to invite you to visit my website, farhatlectures.com for additional resources, especially if you're studying for your CPA, or you'd like to supplement your accounting education. Stay safe, especially during these coronavirus days. Good luck and study hard.