At the end of this section, students should be able to meet the following objectives:
- Define a “serial bond.”
- Identify the steps to calculate the price of a bond and provide the proper accounting.
- Record a serial bond over its life.
- Explain the periodic determination of interest for a serial bond and the amount that must be compounded each period.
Question: The previous section of this chapter looked at term bonds. Interest was paid each period although payment of the face value did not occur until the end of the four-year term. How does this process differ for a serial bond where both interest and a portion of the face value are paid periodically?
To illustrate, assume that Smith Corporation issues a four-year, $1 million serial bond on January 1, Year One, paying a 5 percent stated interest rate at the end of each year on the unpaid face value for the period. The bond contract specifies that $250,000 of the face value is also to be paid annually at the same time as the interest. Smith and the potential investors negotiate for some time and finally agree on a 6 percent annual effective rate. What accounting is appropriate for a serial bond?
Answer: In reporting a term bond, five steps were taken:
- The cash flows required by the bond contract are listed.
- The total present value of these cash flows is computed using the effective rate of interest negotiated by the parties. Present value mathematically removes all future interest at the appropriate rate. Only the principal remains. Thus, this resulting figure is the exact amount to be paid so that the agreed-upon interest rate is earned over the life of the bond.
- The bond is recorded at the principal (present value) amount paid by the investors.
- The debtor pays interest periodically on the dates indicated in the contract.
- The effective rate method is applied. Interest to be reported for each period is determined by multiplying the principal balance of the bond by the effective interest rate. The cash interest figure is adjusted to this calculated amount with the difference compounded (added to the principal)1.
This same process is applied when a serial bond is issued. The sole difference is that additional payments are made periodically to reduce the face value of the debt.
For the Smith Corporation serial bond described above, the following steps are required.
Identify cash flows specified in the bond contract. As a serial bond, Smith is required to pay $250,000 to reduce the face value each year. In addition, the unpaid face value for Year One is $1 million so the 5 percent stated rate necessitates a $50,000 year-end interest payment. Following the first principal payment, the remaining face value is only $750,000 throughout the second year. Thus, the interest payment at the end of that period falls to $37,500 ($750,000 × 5 percent). Based on the contract, the cash flows required by this bond are as follows.
Figure 14.16 Cash Payments Required by Bond Contract
|Year||Beginning Face Value||Cash Interest Rate||Cash Interest||Principal Payment||Ending Face Value|