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Int. Acc. FA LECT 8: CH 19+17 part 3: Investments (Debt investments…
Int. Acc. FA LECT 8: CH 19+17 part 3: Investments
Debt investments-Amortized cost
Now focus on companies purchasing bonds as investment asset
On Jan 1, 2012, company ABC purchases €100,000 bonds paying interest of 6% annually. ABC intends to collect the contractual cash flows (interest payments) and hold the bonds until maturity (5 years).
--> Account for the investment at amortized cost
The market rate of interest is 8% and as a result, the bonds are purchased at a discount (6% < 8%)
We previously focused on companies
issuing
bonds
Debt investments-Amortized cost (II)
Purchaser of the bond (in this case, company ABC) isn’t willing to pay the full face value amount of 100,000, because the bond’s interest rate is lower than the prevailing market rate.
Therefore it purchases the bond at a discount -> this amount is reported as the carrying value of the bond at purchase date.
Intermezzo:
What does it mean if a bond is
issued/purchased at a discount?
However, the bond’s issuer still has to pay 100,000 at maturity, even though the current carrying value < face value.
Debt investments-Amortized cost (III)
Implications?
ABC amortizes the difference (= the discount) between purchase price/initial carrying value over the life of the bond.
At maturity, bond’s carrying value = face value
When ABC receives the principal of 100,000, it can credit the bond investment for the same amount!
Increases carrying value over time
Because bond purchaser (Company ABC) pays less than face value, it effectively earns additional income (on top of cash interest received).
The amortized discount can be seen as an additional source of
interest revenue
for purchaser (and an additional
interest expense
for the bond issuer).
Debt investments-Amortized cost (IV)
The opposite can also happen:
Bond Interest = 8% > market rate of interest = 6
%
Premium is also amortized over the life of the bond, but now it decreases carrying value over time.
At maturity, carrying value = face value (similar to discount)
Purchaser now willing to pay more than face value: bond premium. --> Carrying value > face value
This is called the effective interest rate method.
Step 2: Recording the amortization:
Step 3: Calculate the carrying value of the bonds:
Step 1: Calculate the bond discount amortization for the period
Step 4: Calculate the gain/loss on the sale of bonds
Step 5: Calculate the interest collectible
Step 6: Recording of the sale
Debt investments-Fair value
Accounting procedure:
During the accounting period: Use
amortized cost
--- same as for
“held-to-maturity” investments
At the end of each accounting period: Adjust amortized cost to
fair value
Report any unrealized holding gain or loss as part of net income (i.e., record in the income statement)
Trading investments: purchase bonds with the intention of selling them in a short period of time
Unrealized holding gain/loss: net change in fair value of the (debt) instrument from one period to another