assume historical cost accounting is the tax treatment for bonds and interest (which it is)

Does the historical cost principle apply to liabilities?

The historical cost principle also applies to liabilities. For example, debt instruments are recorded in the balance sheet at their original cost price. Julius owns an investment firm that has acquired various properties across southern America.

What is the historical cost of an asset?

The historical cost of an asset refers to its purchase price or its original monetary value. Based on the historical cost principle, the transactions of a business tend to be recorded at their historical costs.

How are amortized costs used to account for HTM securities?

Finally, if the bond is classified as an HTM security, amortized cost is used to account for the investment. Let’s look at how a bond purchased at a discount is accounted for. Suppose a bond having a ten year maturity has a face value of $1,000 and a coupon rate of 10% but was issued for $900 due to an increase in interest rates to 11%.

What is the accounting treatment for the issue of bonds?

The resulting premium or discount is in the form of interest accumulated and amortized over the life of the bond. The accounting treatment for the issuance of bonds will depend on the amortization of interest and the issue price of the bonds. In most cases, bonds will be issued at other than the par value.

Issuance of Bonds

Companies issue bonds to raise capital from the market. Bonds are typically issued when companies require funding for long-term projects.

Accounting for Issuance of Bonds

The valuation of bonds at the issuance date is the present value of future payments using an interest rate that reflects the risk category of the issued bonds.

Bonds Issued at Par

When bonds are issued at par, the coupon rate offered on the bond and the market interest rate will be the same.

Bonds issued at Premium

Suppose ABC company issues a bond at a par value of $ 100,000 and a coupon rate of 6% with 5 years maturity. The market interest rate is 5%.

Bonds Issued at Discount

Now let us suppose ABC company issues a bond at a par value of $ 100,000 and a coupon rate of 6% with 5 years maturity. The market interest rate is 7%.

Do brokerage firms charge fees for bonds?

d. brokerage firms do not charge a fee for managing the sale of bonds.

Does a corporation issue voting rights to bondholders?

a. the corporation does not issue voting rights to bondholders..

What is an available for sale bond?

A security available for sale- This is a bond that doesn’t fall into either of the above categories. These bonds are recorded at fair value, but any unrealized gain or loss is recorded in Other Comprehensive Income (“OCI”) on the balance sheet net of deferred taxes. [3] Available for sale securities may be either current assets or long-term investments depending on the anticipated liquidation date.

How do bonds fluctuate?

Let’s review some of the basic accounting for bonds. Bond values fluctuate inversely to interest rate. As interest rates rise , bond price decrease. As interest rates decline, bond prices increase. This makes sense since bonds will trade at the prevailing interest rate. No one will buy a bond yielding 7% for face value if the going rate for that maturity and quality of bond is 9%. The bond will have to trade at a discount. Conversely, bonds paying a higher interest rate than the going rate will trade at a premium. A bond paying 10% will fetch a premium in a trade if the market for that maturity and type of bond is paying 9%.

What is fair value option?

Fair Value Option —Accepted accounting principles (“GAAP”) now allows fair value accounting for bonds. Unrealized gains and losses are recognized [1] at each balance sheet date. These gains and losses flow through the income statement, and the carrying value of the bonds are adjusted accordingly.

What happens if a company holds a bond until maturity?

If the company can hold the bond until maturity, there is no risk of market fluctuations. Since the company plans to hold the bond to maturity there is negligible risk of loss due to market fluctuation. [2] A security available for sale- This is a bond that doesn’t fall into either of the above categories.

What is the purpose of a bond record?

To record the purchase of a bond at a discount.

How many different ways can bonds be classified?

The alternative accounting treatment allows bonds to be classified in three different ways, with three different accounting policies and two potential locations on the balance sheet:

Which method of bond amortization is preferred under GAAP?

True or False. The straight-line method of bond discount amortization is the preferred method under GAAP.

What is the borrower's entry?

The borrower’s entry includes a debit in the interest expense account and a credit in the accrued interest payable account. The lender’s entry includes a debit in accrued interest receivable and a credit in the interest revenue.

What is accrued interest?

Accrued interest refers to interest generated on an outstanding debt during a period of time, but the payment has not yet been made or received by the borrower or lender.

What is an adjusting entry for accrued interest?

The adjusting entry for accrued interest consists of an interest income and a receivable account from the lender’s side, or an interest expense and a payable account from the borrower’s side.

How to count the number of days in a coupon payment period?

There are two typical methods to count the number of days in a coupon payment period (T) and the days since the last coupon period (t). One is the actual/actual convention, counting the actual number of days, which is generally used for U.S. Treasury bonds and notes. The other one is the 30/360 convention, assuming 30 days for a month ...

What is accrual interest in accounting?

Accrual-based accounting requires revenues and expenses to be recorded in the accounting period when they are incurred, regardless of when the cash payments are made.

How often are bonds traded?

Bonds can be traded in the market every day, while their interests are usually paid annually or semi-annually. Accrued interest occurs when a bond is not traded on its coupon payment date. It is the part of the interest that a bond buyer gives up from the last coupon payment date to the date the bond is bought.

How to calculate flat price?

The flat price can be calculated by subtracting the accrued interest part from the full price , which gives a result of $1,028.08.

What is interest cost capitalized on?

The amount of interest cost capitalized on qualifying assets acquired with proceeds of tax-exempt borrowings that are externally restricted as specified in the previous paragraph shall be all interest cost of the borrowing less any interest earned on related interest-bearing investments acquired with proceeds of the related tax-exempt borrowings from the date of the borrowing until the assets are ready for their intended use. The interest cost and interest earned on any portion of the proceeds of the tax-exempt borrowings that are not designated for the acquisition of specified qualifying assets and servicing the related debt are excluded.

What is ASC 835-20-55-4?

ASC 835-20-55-4 (Example 1) illustrates the special capitalization rules for interest on tax-exempt debt. For additional information on the interest capitalization rules, see PPE 1.3, Chapter 9 of AAG-NFP, and Chapter 6 of AAG-HCO. Question NP 11-1 addresses the accounting when construction is funded with both tax-exempt and taxable bonds.

What happens to tax exempt bonds?

Once the tax-exempt project is completed, the issuer will continue to incur interest costs on the outstanding bonds. At that point, if the issuer has other construction projects underway, interest on the tax-exempt debt may be capitalizable as part of the other projects, consistent with the “avoidable-interest concept” of the general rules.

When is capitalization period for a loan?

Under the tax-exempt debt rules in ASC 835-20-25-8, the capitalization period begins at the inception of the borrowing and extends through the date that the constructed asset is ready for use. For example, if the financing is executed (and proceeds are received) six months prior to commencing construction, all of the interest cost incurred prior to commencing construction would be capitalized.

Do you capitalize interest on municipal bonds?

During construction of a debt-financed project, interest costs must be capitalized as part of the cost of the asset (or assets). Pursuant to ASC 835-20, the capitalization rules for interest associated with tax-exempt municipal bonds differ from the rules generally used for determining capitalized interest. The primary differences are the dates when capitalization should begin, the calculation of amounts capitalizable during the capitalization period, and the treatment of investment income earned on unexpended bond proceeds. This special treatment, described in ASC 835-20-30-10 is due to the interrelationship of the IRS rules governing permitted uses of bond proceeds, investment income earned on those proceeds, and the plan of financing undertaken.

Is capitalizable interest expense included in current period income?

Under the general rules, because capitalizable interest costs are linked to construction expenditures, the concept of “unexpended proceeds” is irrelevant and thus, any income on those proceeds is included in current period income.

Can interest be capitalized on taxable bonds?

No. In such situations, capitalization of interest on the taxable bonds is determined using the general rules in ASC 835-20-30-2 through ASC 835-20-30-7.

Issuance of Bonds

Accounting For Issuance of Bonds

• The valuation of bonds at the issuance date is the present value of future payments using an interest rate that reflects the risk category of the issued bonds. In many situations, the interest rate agreed upon by both parties may not reflect the actual risk-reward relation. It means the market will ratify the difference whether the interest rate sh...

See more on cfajournal.org

Bonds Issued at Par

Bonds Issued at Premium

Bonds Issued at Discount

Accrual Interest in Accounting

Accrual Interest in Accounting – Example

Accrued Interest in Bonds

Accrued Interest in Bonds – Example

• For example, a Treasury bond with a $1,000 par value has a coupon rate of 6% paid semi-annually. The bond matures in two years, and the market interest rate is 4%. The last coupon payment was made on March 31, and the next payment will be on September 30, which gives a period of 183 days. The coupon payment for each period is $30 ([6%/2] * $1,000)....

See more on corporatefinanceinstitute.com

Additional Resources