Let Us Peep into the External Auditors’ Exit Conference with Jewel Corporation…
The exit conference of the external auditors with the management of the Jewel Corporation is attended by all department heads together with the members of the Board of Directors and the company’s internal auditor, Mr. Canes. According to the audit report, generally accepted accounting principles are perfectly applied to the financial statements. Even the latest principles on investments are immediately implemented. The external auditors also noted a remarkable increase in the net income compared to that of last year’s operations. However, external auditors are wary about the growing delinquent accounts and the company’s idle funds. But just before the conference was conducted, the Chairman of the Board, Mr. Stevens, mentioned to the group that after the current business year Jewel management will revamp the entire credit and collection office in order to address the issue of delinquent accounts. The system in granting and collecting accounts will also be rehabilitated, and there will be a reshuffling of employees.The Board of Directors’ resolution on idle funds is to invest them in bonds starting next month, April. The meeting ended with the suggested work plan for delinquent accounts and idle funds.
What is a Bond Investment and How is It Classified?
To proceed with accounting for bond transactions, one must recognize that a bond is a debt investment in which the investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states, and both the U.S. and foreign governments to finance a variety of projects and activities.
Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents, and such investment is categorized as a financial debt instrument asset.
Bonds may be acquired as current or noncurrent investments, depending on the business model of managing financial assets. In the new International Financial Reporting Standard No. 9, particularly on debt instruments where bond investment is included, a debt instrument must possess two features that will make it qualified as an investment valued at its amortized cost (noncurrent asset). If not, such instrument will be valued at its fair market value through profit or loss (current).
Two features that a financial instrument must possess in order to be classified as an investment valued at its amortized cost are as follows:
1. The company has the intention to hold the financial asset and at the same time collects the contractual cash flows (rather than selling the instrument prior to its contractual maturity to realize its fair value changes).
2. The instrument has contractual terms that will give rise on specified dates to cash flows that are solely payments of the principal and interest on the principal outstanding.
Before recording the bond acquisition, the accountant should know if bonds acquired are considered as current or noncurrent investments. Tests should be accompanied with a careful analysis before classifying them according to the business model applied in managing financial assets above.
How are Bond Investment Acquisition Recorded?
Short-Term Bonds - Recorded at Fair Value Through Profit or Loss
Account Title: “Trading Securities”
Going back to Jewel Corporation, in order to address the issue on idle funds, Mr. Stevens, along with the other members of the Board, agreed on a motion to buy bonds. So on April 1, 2009, the company purchased $1,000,000, 12% bonds at 96% plus accrued interest. Interest is collectible January 1 and July 1.
To record the above transaction, the Trading Securities account of $960,000 ($1,000,000 multiplied by .96) and the Interest Income account of $30,000 ($1,000,000 multiplied by .12 multiplied by 3 months/12 months (January 1 to April 1) were created. $990,000 cash is used to pay the securities and the interest income.
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How are Bond Investment Acquisitions Recorded?
Mr. Stevens is elated because the investment will bring in big returns. This kind of security is actively traded in the current market. Mr. Canes said that short-term bonds are sec
urities that can be traded like stocks. Jewel need not hold the bond for its entire term and the bond’s interest rate remains fixed throughout its entire term. Jewel will only most likely have to pay more than its face value for a bond if it is issued during those times when interest rates are higher, so its effective or actual yield will be close to that of similar newly issued bonds. This sensitivity to interest rate changes can cause the total gains of the investment to be less than 100% predictable. To minimize this uncertainty, Jewel should try to purchase a bond that matures fairly close to its target date for selling. What is needed for short-term bonds, therefore, is a strategy in bond trading, and Jewel’s management needs knowledge on that! An experienced financial adviser can help, though.
Although Jewel is enjoying high returns from the short-term investment ever since it was invested, Mr. Stevens knows that it is not practical to put all the company’s eggs in one basket, so he thought of inquiring of other kinds of investments that would give the company a portfolio of investments with varied features.
Mr. Canes suggested an investment in long-term bonds that will give the company a steady cash flow for several years. Together with the other members of the Board of Directors, a careful analysis was made with regard to the investment. After related facts were ironed out and before the end of 2009, a motion was agreed to invest on a long-term bond that will be pursued in April 2010.
Long Term Bonds - Valued at Amortized Cost in Recording Long-Term Bonds
Account Title: “Investment in Bonds”
On April 1, 2010, Jewel Corporation purchased $1,000,000 face-value, 12% bonds at 94%. Interest income is paid semiannually, April 1 and October 1, and the bonds will mature on April 1, 2015.
The accounting for bond transactions such as the above is recorded as: Investment in bonds amounting to $940,000 ($1,000,000 multiplied by 94% or .94. Inasmuch as the acquisition is on an interest date, April 1, there is no accrued interest involved. If there is, it will use the same procedure as that used in the recording of trade securities. The account title “Investment in Bonds” will also be used instead of “Trading Securities.” It is also understood that this kind of bond possesses the two features needed to be qualified as an investment valued at its amortized cost.
As a summary of the above purchase: In recording an investment valued at amortized cost regarded as a noncurrent asset, the account title used is “Investment in Bonds.” Unlike trading securities, any incidental expenses pertaining to the acquisition should be added to the acquisition cost.
Bonds are invested to earn interest income. Normally, they are collected and recorded on interest dates and at the end of each accounting period (usually December 31 - a calender year-end date), interest receivable is taken up. Interest receivable occurs if the interest date is not the same as the accounting year-end date (Example: Interest dates are April 1 and October 1 while the company year-end date is December 31.) To explain further, after October 1, the next collection date is April 1, but since the books have to be closed on December 31, the interest earned from October 1 to December 31 has to be recorded in compliance with the commonly used accrual accounting method.
Current and noncurrent bond investments have the same procedures of recording interest collection and year-end interest collectibles. Current assets are those assets which include cash and other assets that can be converted into cash within one accounting year, while noncurrent assets are those assets that cannot be converted into cash within one year.
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Recording Interest Collection and Year-End Updating Entries
Let us discuss the current short-term bond investment of Jewel Corporation, to help clarify the accounting for bond transactions:
The interest dates of the $1,000,000 investment are January 1 and July 1. On July 1, the company will receive cash of $60,000 which represents interest income for three months, April 1 to July 1, that is computed as follows: $1,000,000 multiplied by .12 multiplied by 3 months/12 months. On December 31, the interest receivable from the month of July 1 to December 31 is $24,000 computed as: $400,000 multiplied by .12 or 12% multiplied by 6 months/over 12 months. $400,000 is assumed to be the remaining amount of bonds at the end of the period.
For the noncurrent bond investment, the semiannual interest is $60,000 and is received on October 1. The accrued interest at the end of December is $30,000 ($1,000,000 multiplied by .12 or 12% multiplied by three months (October 1 to December 31).
Unlike the current bond investment, another important end-of-year entry for noncurrent bonds is the amortization for either bond premium or discount. When does a discount or premium occur in a long-term investment? It happens when the face value of the bonds is different from its acquisition price. If the face value of the bonds is greater than the acquisition price, there is a discount; and if the acquisition price is bigger than the face value, there is a premium.
Philosophy on the Amortization
The reason for amortization of bond premium or discount is to bring the investment balance to its fair value on the date of maturity. The bondholder is a creditor and will collect on the date of maturity an amount equal only to the face value of the bonds, no more and no less.
The bond premium is a loss on the part of the bondholder because the bondholder paid more than what can be collected on the date of maturity. Such loss is not recognized outright but allocated over the life of the bonds; it will be offset against the interest income to be derived from the bond investment.
On the other hand, bond discount is a gain on the part of the bondholder because the bondholder paid less than what can be collected on the date of maturity. Such is not recognized outright but allocated over the life of the bonds to be added to the interest derived from the bond investment.
To continue with the noncurrent bond investment, the discount on the investment is $60,000 or the cost of $940,000 deducted from its fair value of $1,000,000.
The annual amortization is $12,000, which resulted from dividing the total discount of $60,000 over 5 years. The actual discount to be amortized is $9,000 computed as $12,000 a year/12 multiplied by 9 months.
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Accounting on the Selling of Short-Term and Long-Term Bonds
In selling trading securities and bonds valued at amortized cost, accounting for bond transactions of both types will compare the selling price and the carrying value.
There is a gain if the selling price is bigger than the carrying value. However, those valued at amortized cost bonds will include the amortization of either the bond discount or the premium in getting the result for the carrying value.
Going back to Jewel Corporation: If, for example, on October 31 the company decided to sell $600,000 face-value bonds at 101% plus accrued interest there would be a gain of $30,000 computed as follows:
Sales Price ($600,000 multiplied by 1.01 or 101%) $606,000
Less: Carrying amount of bonds sold (6/10 multiplied by $960,000) $576,000
Gain on Sale of Trading Securities $30,000
Valued at Amortized Cost
If, for example, on December 31, Jewel Corporation decided to sell its long-term bonds at 1.05 or 105%, the gain on sale of its long-term bonds would be:
Selling Price $1,000,000 multiplied by 1.05 or 105% $1,050,000
Less: Original Cost $940,000
Amortization of Discount 12.31 $9,000, $949,000
Gain on Sale on bonds $101,000
How are Bond Investment Decisions Done Wisely?
As an investor, Jewel Company has two big choices for investments: bonds, if it wanted to be a creditor, and stocks, if it wanted to be a stockholder.
If the company is looking for a steady stream of income, bonds are a means of achieving that goal. Receiving steady interest at set intervals can provide cash flow or additional income, which can be beneficial, especially in maintaining liquidity.
The amount of its portfolio devoted to bonds should depend on how much risk it is willing to take, its investing goals and current needs, plus economic conditions. At different times, the company will want to move more money into the safer bonds market, particularly when approaching times in the business cycle where it cannot afford to be in high-risk investments. Using bonds wisely can contribute very well to the company’s portfolio. When considering a bond investment strategy, it has to remember the importance of diversification. As a general rule, it’s never a good idea to put all assets and all risk in a single-asset class or investment. The company must diversify the risks within its bond investments by creating a portfolio of several bonds, each with different characteristics. Choosing bonds from different issuers protects the company from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal.
Conclusion: What is the Effect of Bond Investments to the Company’s Profitablity and Liquidity?
Bonds are investments that will help the company in maintaining its liquidity and profitablity, if properly managed.
To properly manage these investments, the decision makers should understand very well what and how these investments will be in terms of effective contributors to the company’s profitability and liquidity.
One important thing to bear in mind if management wants bigger returns from investments: There are more risks to handle with them, and vice versa. It is essential to know when to invest in short-term and long-term bonds. However, It is not practical to put all eggs in one basket so that wise investors maintain a portfolio of investment with varied features. It is best to monitor bond inclusion in the trading market, and it is also a wise decision to consider other forms of investments like stocks and cash equivalents, if they will give the company a better stand in terms of profitability and liquidity.
Just like any investments, the success of bond investments also depends on a number of factors: economic conditions, management style, customer taste and preference, and competitors’ strengths.
Webpage, Book, and Image Credits:
Deloitte and IAS, IFRS 9 standards, retrieved at https://www.iasplus.com/standard/ifrs09.htm
Financial Accounting Book, Vvolume 1 by Valix and Peralta 2010 edition
https://www.freeimages.co.uk/ building 00001p