Companies raise finance through several sources. One of these includes bonds, which are fixed-income instruments. For companies, these represent debt finance, which can help fund operations. Bonds are also interest-bearing instruments that can result in interest charges in the financial statements. These instruments provide an alternative method of obtaining finance apart from equity. However, it may come with some disadvantages.
Bonds can be significantly beneficial in helping companies fund operations. Usually, they come with fixed interest rates, which can be easy to calculate and estimate. On top of that, bonds include various forms, each involving some advantages. However, they may also come with some drawbacks. Apart from companies, other organizations can also use bonds to raise capital. These include governments, municipalities, etc.
Bonds allow companies to raise finance based on the face value. However, companies may also charge more or lesser than this value. These fall under premium or discounts. Depending on the terms, companies may also dictate other aspects of the issuance of bonds. These factors also play a role in the carrying value of a bond. Before understanding that, it is crucial to know some terms associated with the process.
What are the characteristics of a Bond?
Bonds have several characteristics which set them apart from other instruments. These features also dictate the type of bond that companies issue. On top of that, they play a role in several calculations involving bonds, like the carrying value. Some of the fundamental characteristics of a bond include the following.
The face value of a bond is the amount that it will be worth at maturity. In some cases, this value also represents the amount that companies will receive. However, premiums and discounts also play a role in that. Furthermore, the face value of a bond also plays a role in calculating coupon payments.
Maturity is when the bond issuer returns the money lent by the bondholder. In other words, it is when the bond expires. At this date, the issuer repays the holder the face value of the bond. Any coupon payments outstanding will also be payable on this date.
A premium is when a company issues a bond at a value higher than its face value. For example, when an issuer charges $105 for a $100 bond, the issuance is at a premium. However, any amount exceeding the face value is not repayable to the holder at maturity. This amount becomes income for the company. However, it does not play a role in calculating coupon payments.
A discount is the opposite of a premium. When a company charges lower than the bond’s face value, it falls under a discount. Unlike the premium amount, companies still have to repay holders the face value. Therefore, any discount offer on the bond becomes an expense for the company. Similarly, the discount does not impact the coupon payments calculation on the bond.
How to calculate the Carrying Value of a Bond?
When calculating the carrying value of a bond, companies must go through several steps. These steps are crucial in how much the value will be. On top of that, these steps ensure that companies can calculate the bond’s carrying value reliably. Companies may require several figures to put into the calculations. Overall, the steps to calculate the carrying value of a bond are as follows.
Determine the terms of the bond
The first step for companies to calculate the carrying value of a bond is to determine its terms. These terms include whether the company sold the bonds at a premium or discount. On top of that, companies must establish the time elapsed since the issuance of the underlying bond. Once they have this information, they can measure the amortization of the premium or discount. Similarly, this amortization relates to the time elapsed since the bond’s issuance.
Calculate the amortized portion of the discount or premium
After determining the terms, companies must calculate the amortized portion of the discount or premium. In most cases, the amortization occurs on a straight-line basis. It implies that it will happen for the same amount each year. Companies must establish the remaining unamortized discount or premium for the carrying value calculation.
For example, a company issued a 5-year bond with a $50 discount a year ago. Annually, the company records amortization of $10 ($50 / 5 years). Since the company issued the bond a year ago, it has recorded $10 in amortization. Therefore, the unamortized value of the premium is $40 ($50 premium value – $10 amortization).
Calculate the carrying value of the bond
Once companies calculate the unamortized value of the bond, they can measure its carrying value. This value will be equal to the face value of the bond and its remaining unamortized amount. While this step is straightforward, it may differ for discounts and premiums. Nonetheless, calculating the carrying value of the bond will be similar.
For bonds issued at a premium, the carrying value is as follows.
Carrying value of bond = Face value + Unamortized premium
For bonds issued at a discount, the same formula will not apply. Instead, companies must subtract the unamortized discount from the bond’s face value. Calculating the unamortized amount is the same for both types of bonds. However, the carrying value of the bond formula will differ as below.
Carrying value of bond = Face value – Unamortized premium
Based on the carrying value of bond formulas, companies can measure the amount for all bonds. However, the previous steps play a crucial role in determining how much this carrying value will be. Therefore, all stages are critical for an accurate and reliable calculation.
A company, ABC Co., issues bonds with a face value of $100 for ten years. However, the company charges $110 per bond. It implies ABC Co. got a premium of $10 per bond. The company wants to calculate the carrying value of its bond three years after its issuance. Consequently, ABC Co. must use the above steps to measure the carrying value.
The first step, as mentioned, is to determine the terms of the bond. The first includes whether ABC Co. issued these bonds at a premium or discount. As mentioned, the company charged $10 more than the bond’s face value. Therefore, it falls under a premium. ABC Co. must also determine the time elapsed since the bond’s issuance. In this case, it is three years.
Subsequently, ABC Co. must calculate the amortized portion of the premium. The company uses a straight-line basis to calculate its amortization. Therefore, the annual amortization charge on the bond will be $1 ($10 / 10 years). Until now, ABC Co. has recorded an amortization of $3 ($1 x 3 years) on the bond’s premium. On the other hand, the unamortized premium will be $7 ($105 – $3).
Lastly, ABC Co. must calculate the bond’s carrying value. As mentioned, the company must use one of the two formulas above. Since this scenario involves a bond issued at a premium, the company must use the respective formula. Therefore, the calculation for the carrying value of the issued bond will be as below.
Carrying value of bond = Face Value + Unamortized premium
Carrying value of bond = $100 + $7
Carrying value of bond = $107
A bond is a debt instrument issued by companies to raise finance. This instrument holds various characteristics.
Within these features, the face value, maturity, premium, and discount are crucial in calculating its carrying value. Companies can calculate this value by following several steps. These steps help calculate the carrying value of a bond reliably.