ACG 3171 Final Exam Study Guide Analysis of Financial Statement Presentations Professor Gilliam 1 Bond Basics Chapter 11 a Principal amount par value maturity value face value b Stated interest rate coupon rate nominal rate c Cash interest principal stated interest rate d Face value typically 1 000 but the PRICE of the bond can and will differ i Bonds can sell at face value with discounts or at premiums ii Par Issue price face value iii Discount Issue price face value interest rates are up iv Premium Issue price face value interest rates are down e The issue price and the stated interest rate are used to determine the effective yield the true rate of return f When a bond is sold at par its effective yield is the stated rate g The market for bonds that lack active trading can have large differences between retail and wholesale prices unlisted pricing a OPM issues bonds with a total face value of 1 000 000 and 10 interest at par b or face value no discount or premium This transaction is simply an exchange of a liability for cash plus an on going interest expense i OPM s initial journal entry 2 Example Bonds payable DR Cash 1 000 000 CR Bonds Payable 1 000 000 Annual interest payment DR Accrued interest payable 100 000 CR Cash 100 000 c Example 2 If the rates rise and the bond is issued at a Discount i OPM issues bonds with a face value of 1 000 000 at 10 per year when the rates are 11 ii The selling price that will yield an 11 return to the bond buyers is 941 108 iii As with Notes Receivable the bond is recorded at Present Value PV as sellers we will always know this amount because it is the selling price DR Cash 941 108 DR Bond Discount face value and selling price 1 000 000 941 108 58 892 58 892 this is the difference between CR Bonds payable par 1 000 000 How to set up the above journal entry 1 Start with a DR to Cash for the selling price of 941 108 2 Next CR Bonds Payable liability for the face value of 3 Last DR Bond Discounts for the difference this serves as a 1 000 000 contra account From this point on you record yearly interest expense DR Interest expense 103 522 941 108 11 actually owed 1 000 000 10 CR Accrued interest payable 100 000 this is what you 3 522 this number is the difference between your interest expense and accrued interest payable 103 522 100 000 this reduces the contra account that originally had 58 892 CR Bond Discount d Example 3 OPM problem but rates decline and the bonds are issued at a premium i OPM s accounting entry when their 10 bonds par 1 000 000 are issued at a price of 1 064 177 that yields 9 therefore at a premium DR Cash 1 064 177 given CR Bond Premium 64 177 difference between issued price and par value 1 064 177 1 000 000 64 177 aka premium this serves as a contra account CR Bonds payable par 1 000 000 To record subsequent interest expense DR Interest expense 95 776 1 064 177 09 subtracting your actual interest expense i e 1 064 177 09 95 776 from what your interest expense would be at par i e 1 000 000 10 100 000 i e 100 000 95 776 4 224 this number gets subtracted from the original contra account of 64 177 DR Bond Premium 4 224 you get this number by CR Accrued interest payable interest payable will always be from the original par value number i e 1 000 000 10 100 000 100 000 the accrued 3 Basic types of derivative instruments a Forward contract specified price Two parties agree to a sale on future settlement date at a i Two parties agree to the sale of some asset on some future date settlement date at a price specified today 1 Ex you order a laptop online and the final price is 1 000 when the laptop arrives you pay the predetermined price of 1 000 and take delivery 2 Three elements of the contract are key a The agreed upon price to be paid in the future b The delivery date c The buyer will actually take delivery b Futures contract market no specified settlement date Variation of forward contract traded daily in financial exchange i Two parties agree to the sale of some asset on some indefinite future date at a price specified today 1 On October 5th one side of the party sells a February cotton contract to LS Co for 10 million pounds at 0 95 per pound Anytime in February LS Co pays 0 95 per pound and takes delivery from seller 2 Futures contracts are like forward contracts except a They do not have a predetermined settlement date b They are actively traded on financial exchange 3 Settlement can occur through delivery or by creating a zero net position Which means you buy an offsetting contract with the like terms 4 Benefits to the seller a Delivery price is locked in does not have to worry about b Cash receipts are predictable not subject to market market risks fluctuations c Futures contracts are used a lot with agricultural product Farmers plan months ahead of time what crop they want to plant and harvest The farmers want to lock in a price say for wheat maybe 1 000lbs at 2 00 lb to ensure that they 5 Benefits to the buyer market risks are able to make a profit If the farmers didn t have the futures market they could possible decide to plant wheat and harvest and grow it and when they go to sell it in the future the price could have dropped resulting in them not making any profit for the wheat they spent 6 months growing a Delivery price is locked in does not have to worry about b The buyer is hoping to make a profit off the futures contract as well They are guessing that the price of wheat will be more expensive then the agreed upon 2 00 lb when the delivery time comes 6 months in the future If the actual price of wheat 6 months into the future is 2 20 lb then the buyer of the futures contract just made 0 20 lb times the agreed 1 000 lbs they purchased He makes this profit because he agreed to pay 2 00 lb and that s what he will pay then he will immediately sell the 1 000 lbs of wheat for the current price of 2 20 lb The farmer could have made 0 20 lb more if he never entered a futures contract but that s the cost of the insurance to make a guaranteed 2 00 lb 6 The futures contracts eliminate both downside risk and upside potential one stream of future interest payments exchanged for another c Swap contract can also be used …