Question

(Bond Theory: Balance Sheet Presentations, Interest Rate, Premium)

On January 1, 2017, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. The following are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date.

1.	Bonds payable (maturing January 1, 2037)	$1,000,000
	Unamortized premium on bonds payable	85,800
	Total bond liability	$1,085,800
2.	Bonds payable—principal (face value $1,000,000 maturing January 1, 2037)	$  142,050a
	Bonds payable—interest (semiannual payment $55,000)	943,750b
	Total bond liability	$1,085,800
3.	Bonds payable—principal (maturing January 1, 2037)	$1,000,000
	Bonds payable—interest ($55,000 per period for 40 periods)	2,200,000
	Total bond liability	$3,200,000

Instructions

(a)  

Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.

(b)  

Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.

(c)  Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose:

1.The coupon or nominal rate.

2.The effective or yield rate at date of issue.

(d)  

If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest?

Answer 1

Answer

A)

1.This is a common statement of financial position presentation and has the advantage of being familiar to users of financial statements. The total of $1,085,800 is the objectively determined exchange price at which the bonds were issued. It represents the fair value of the bond obligations given. Thus, this is in keeping with the usual accounting practice of using exchange prices as a primary source of data.

2.This presentation indicates the dual nature of the bond obligations. There is an obligation to make periodic payments of $55,000 and an obligation to pay the $1,000,000 at maturity. The amounts presented on the statement of financial position are the present values of each of the future obligations discounted at the initial effective rate of interest. The proper emphasis is placed upon the accrual concept, that is, that interest accrues through the passage of time. The emphasis upon premiums and discounts is eliminated.

3. This presentation shows the total liability which is incurred in a bond issue, but it ignores the time value of money. This would be a fair presentation of the bond obligations only if the
effective-interest rate were zero.

B) When an entity issues interest-bearing bonds, it normally accepts two types of obligations: (1) to pay interest at regular intervals and (2) to pay the principal at maturity. The investors who purchase Nichols Company bonds expect to receive $55,000 each January 1 and July 1 through January 1, 2037 plus $1,000,000 principal on January 1, 2037. Since this ($55,000) is more than the 10% per annum ($50,000 semiannually) that the investors would be willing to accept on an investment of $1,000,000 in these bonds, they are willing to bid up the price—to pay a premium for them. The amount that the investors should be willing to pay for these future cash flows depends upon the interest rate that they are willing to accept on their investment(s) in this security.

The amount that the investors are willing to pay (and the issuer is willing to accept), $1,085,800, is the present value of the future cash flows discounted at the rate of interest that they will accept.

Another way of viewing this is that the $1,085,800 is the amount which, if invested at an annual interest rate of 10% compounded semiannually, would allow withdrawals of $55,000 every six months from July 1, 2017 through January 1, 2037 and $1,000,000 on January 1, 2037.Even when bonds are issued at their maturity value, the price paid coincides with the maturity value because the coupon rate is equal to the effective rate. If the bonds had been issued at their maturity value, the $1,000,000 would be the present value of future interest and principal pay­ments discounted at an annual rate of 11% compounded semiannually.

Here the effective rate of interest is less than the coupon rate, so the price of the bonds is greater than the maturity value. If the effective rate of interest was greater than the coupon rate, the bonds would sell for less than the maturity value.

C)

1.The coupon or nominal rate.

The use of the coupon rate for discounting bond obligations would give the face value of the bond at January 1, 2017, and at any interest-payment date thereafter. Although the coupon rate is readily available while the effective rate must be computed, the coupon rate may be set arbitrarily at the discretion of management so that there would be little or no support for accepting it as the appropriate discount rate.

2.The effective or yield rate at date of issue.

The effective-interest rate at January 1, 2017 is the market rate to Nichols Company for long-term borrowing. This rate gives a discounted value for the bond obligations, which is the amount that could be invested at January 1, 2017 at the market rate of interest. This investment would provide the sums needed to pay the recurring interest obligation plus the principal at maturity. Thus, the effective-interest rate is objectively determined and verifiable.The market or yield rate of interest at the date of issue should be used throughout the life of the bond because it reflects the interest obligation which the issuer accepted at the time of issue. The resulting value at the date of issue was the current value at that time and is similar to historical cost. Also, this yield rate is objectively determined in an exchange transaction.The continued use of the issue-date yield rate results in a failure to reflect whether the burden is too high or too low in terms of the changes which may have taken place in the interest rate.

D) Using a current yield rate produces a current value, that is, the amount which could currently be invested to produce the desired payments. When the current yield rate is lower than the rate at the issue date (or than at the previous valuation date), the liabilities for principal and interest would increase. When the current yield is higher than the rate at the issue date (or at the previous valuation date), the liabilities would decrease. Thus, holding gains and losses could be determined. If the debt is held until maturity, the total of the interest expense and the holding gains and losses under this method would equal the total interest expense using the yield rate at issue date.