The financial accounting and reporting (FAR) test covers topics related to accounting transactions and generating financial statements. This test is all about the day-to-day work of accounting. One tricky section on this part of the CPA exam is accounting for bonds. Use these tips to prepare for test questions related to bonds.
A bond is a debt instrument issued by the federal government, an agency, municipality or a corporation. The buyer of a bond is a creditor that earns interest income at a stated rate, and then is repaid their principal (original investment) at maturity. Bonds are typically issued in multiples of $1,000, which is also referred to as the bond’s par value.
There are two difficult bond concepts that are frequently on the FAR test- accrued interest and the concept of bond premium amortization. Use these tips to get a solid understanding of these two areas.
Accrued interest is income that that buyer of a bond owes the seller, because the bond sale occurs between interest payment dates. The bond issuer pays interest to the person who owns the bond when the interest is due- regardless of how long that person has owned the bond. Because the issuer only pays interest to one person, bond buyers must pay sellers accrued interest.
Here’s an example. Assume that Bob buys a $1,000 6% IBM corporate bond from Susie on February 1st. The bond pays $30 interest on January 1st and June 1st of each year. Accrued interest for corporate bonds assumes 30 days in each month.
On June 1st, IBM (the issuer) pays Bob the entire six months of interest even though he only owed in the bond for five months. So, to get Susie the interest she is owed ($30 / 6 months = $5), Bob pays Susie $5 extra when he buys the bond. If the price of the bond is $1,000, for example, Bob will pay $1,005 to Susie.
Amortizing a bond premium
While the par value of a bond is $1,000, the market price of a bond changes, just like other investments. Changes in interest rates and the credit quality of the bond issuer, for example, will impact the price of a bond. If a bond is sold at a price above par, the price is referred to as a premium.
Let’s assume that Bob purchases a $1,000 6% 10-year IBM corporate bond for $1,100. Ignore accrued interest for this example and assume that the extra $100 above par is entirely a bond premium. Well, why would someone pay more than $1,000 for a bond? The most common reason is because the 6% interest rate is higher than other bonds in the market. If bonds of similar credit quality and maturity pay 5%, for example, a 6% bond is more valuable.
The extra $100 is an additional expense to the buyer. As a result, the amount of the premium is reclassified as an expense over the life of the bond using a process called amortization. In this case, the bond premium is amortized over 10 years.
There are several methods for bond amortization, but keep in mind that all methods reclassify the entire premium amount into bond expense by the time the bond matures. Using a straight-line method, for example, the amortization would be ($100 / 10 years = $10 a year).
A bond buyer can also buy a bond at a discount, which is less than $1,000 per bond. If that’s the case, the amount of the discount is amortized into bond income over the life of the bond.
These two concepts are frequently tested, so take the time nail down these concepts and work practice questions. If you are confident about these concepts, you can succeed on the FAR test.