The Carrying Value Of Bonds Payable Equals

[Alayna Rother]

Thisarticle was co-authored by Michael R. Lewis. Michael R. Lewis is a retired corporate executive, entrepreneur, and investment advisor in Texas. He has over 40 years of experience in business and finance, including as a Vice President for Blue Cross Blue Shield of Texas. He has a BBA in Industrial Management from the University of Texas at Austin.

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Companies issue bonds in order to raise capital. However, market interest rates and other factors influence whether the bond is sold for more (at a premium) or less (at a discount) than its face value. The premium or discount is amortized, or spread out, on financial statements over the life of the bond. The carrying value of a bond is the net difference between the face value and any unamortized portion of the premium or discount. Accountants use this calculation to record on financial statements the profit or loss the company has sustained from issuing a bond at a premium or a discount.

Bonds can be issued at a premium, at a discount, or at par. Their pricing depends on the difference between its coupon rate and the market yield on issuance. When a bond is issued, the issuer records the face value of the bond as the bonds payable. They receive cash for the fair value of the bond, and the positive (negative) difference (if any) is recorded as a premium (discount) on bonds payable.

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When a bond sells at a discount, a price less than face value, the amount of the discount is deducted from Discount on Bonds Payable. The face amount recorded in bonds payable less the unamortized discount recorded in the discount on bonds payable account equals the bond's carrying value.

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Calculating the carrying value of a bond

The effective interest method is the most common way to amortize premiums and discounts, and perhaps one of the easiest methods for calculating carrying values. (See the article on straight-line amortization if you're interested in calculating the value of a bond via another method.)

Let's assume that a company issues three-year bonds with a face value of $100,000 that have an annual coupon of 9%. Investors view the company as being relatively risky; thus, they are willing to willing to buy this bond only if it offers a higher yield of 10%.

Calculating the carrying value of a bond using the effective interest method is as simple as calculating what the bond would be worth at a given yield to maturity. As yield to maturity goes up, the value of the bond will go down. Similarly, as yield to maturity goes down, the value of the bond will go up, resulting from the bond's "inverse relationship" with interest rates.

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Upon repayment, bonds payable are reduced by the carrying amount (face value), and cash is reduced by the same amount. The repayment of bonds will appear in the statement of cash flows as a financing cash outflow.

In bond redemptions, bonds payable is reduced by the carrying amount of the redeemed bonds. The difference between the cash required to redeem the bonds and the carrying amount of the bonds is a gain or loss on the extinguishment of debt.

In a statement of cash flows, prepared using the indirect method, net income is adjusted to remove any gain or loss on the extinguishment of debt from operating cash flows. The cash paid to redeem the bonds are classified as cash used for financing activities.

Xtrata issued a 5-year accumulative bond at face value with an annual coupon rate of 5% in 2015. Two years after issuance, the company decided to redeem the bond. Knowing that the current market rate for the bond is 7%, which of the following would be the most appropriate value for the bond?

In accounting, book value is the value of an asset[1] according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets[clarification needed] minus intangible assets and liabilities.[2] However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both.[3] The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be tangible book value.

An asset's initial book value is its actual cash value or its acquisition cost. Cash assets are recorded or "booked" at actual cash value. Assets such as buildings, land and equipment are valued based on their acquisition cost, which includes the actual cash cost of the asset plus certain costs tied to the purchase of the asset, such as broker fees. Not all purchased items are recorded as assets; incidental supplies are recorded as expenses. Some assets might be recorded as current expenses for tax purposes. An example of this is assets purchased and expensed under Section 179 of the U.S. tax code.[citation needed]

Monthly or annual depreciation, amortization and depletion are used to reduce the book value of assets over time as they are "consumed" or used up in the process of obtaining revenue.[4] These non-cash expenses are recorded in the accounting books after a trial balance is calculated to ensure that cash transactions have been recorded accurately. Depreciation is used to record the declining value of buildings and equipment over time. Land is not depreciated. Amortization is used to record the declining value of intangible assets such as patents. Depletion is used to record the consumption of natural resources.[5]

Depreciation, amortization and depletion are recorded as expenses against a contra account. Contra accounts are used in bookkeeping to record asset and liability valuation changes. Accumulated depreciation is a contra-asset account used to record asset depreciation.[6]

When a company sells (issues) bonds, this debt is a long-term liability on the company's balance sheet, recorded in the account Bonds Payable based on the contract amount. After the bonds are sold, the book value of Bonds Payable is increased or decreased to reflect the actual amount received in payment for the bonds. If the bonds sell for less than face value, the contra account Discount on Bonds Payable is debited for the difference between the amount of cash received and the face value of the bonds.[10]

A mutual fund is an entity which primarily owns financial assets or capital assets such as bonds, stocks and commercial paper. The net asset value of a mutual fund is the market value of assets owned by the fund minus the fund's liabilities.[11] This is similar to shareholders' equity, except the asset valuation is market-based rather than based on acquisition cost. In financial news reporting, the reported net asset value of a mutual fund is the net asset value of a single share in the fund. In the mutual fund's accounting records, the financial assets are recorded at acquisition cost. When assets are sold, the fund records a capital gain or capital loss.[citation needed]

A company or corporation's book value, as an asset held by a separate economic entity, is the company or corporation's shareholders' equity, the acquisition cost of the shares, or the market value of the shares owned by the separate economic entity.

A corporation's book value is used in fundamental financial analysis to help determine whether the market value of corporate shares is above or below the book value of corporate shares. Neither market value nor book value is an unbiased estimate of a corporation's value. The corporation's bookkeeping or accounting records do not generally reflect the market value of assets and liabilities, and the market or trade value of the corporation's stock is subject to variations.

A variation of book value, tangible common equity, has recently come into use by the U.S. federal government in the valuation of troubled banks.[13][14] Tangible common equity is calculated as total book value minus intangible assets, goodwill, and preferred equity, and can thus be considered the most conservative valuation of a company and the best approximation of its value should it be forced to liquidate.[15]

Since tangible common equity subtracts preferred equity from the tangible book value, it does a better job estimating what the value of the company is to holders of specifically common stock compared to standard calculations of book value.

The issue of more shares does not necessarily decrease the value of the current owner. While it is correct that when the number of shares is doubled the EPS will be cut in half, it is too simple to be the full story. It all depends on how much was paid for the new shares and what return the new capital earns once invested. See the discussion at stock dilution.

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