Chapter 4A Income- Exclusions

Bonds and Original Issue Discount

Edited September 14, 2008

Original Issue Discount. Pg. 114• Some debt instruments are issued at

prices below their maturity values• This original issue discount (OID) is

effectively interest paid at maturity rather than periodically over the debt instrument’s life

• Both cash and accrual basis taxpayers recognize OID income as it accrues– Exception: Series EE bonds

Market Discount. • Bonds purchased after issue in the open

or secondary market at a price below maturity value.–Excess of redemption proceeds over

cost is recognized as ordinary income in year of redemption.–Electively, market discount can be

accrued as interest income over life of bond.

Bond IIlustration – Slide 1 of 11On 1-1-07, issue $100,000 of bonds.On 12-31-08 the bonds will mature.Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. On 1-1-07, Bob buys the bonds from the Corp. at a price to yield 12% (semi-annual compounding). Compute price paid by Bob by discounting cash flows at 6% per interest period.

June Dec. June Dec

PV $5,000

PV $5,000

PV $5,000

PV $5,000

PV $100,000

Price

Bond IIlustration – Slide 2 of 11

2007 2008

PV of $100,000, 4 periods, 6% per periodPrincipal Payment 100,000.00$ Factor =1/(1+0.06)^4 0.792093663PV of $100,000 payment 79,209.37$

PV of 4 interest paymentsInterest Payments 5,000.00$ PV Factor from table=PV(0.06,4,-5000,,0)

PV of $5,000 payments $17,325.53Total issue price of bonds 96,534.89$

Bonds – Slide 3 of 11.

Bond IIlustration – Slide 4 of 11Prepare amortization table.Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables (because of rounding in the tables).

Book Interest Interest Unamort Book

Yr Value Received Income Amort. Disc/Prm Value

2007 96,535

2007

2008

2008

Bond IIlustration – Slide 5 of 11. On Jan. 1, 2007, issued $100,000, 10%, 2 year bonds.

Interest is paid on 6-30 and 12-31. Mature 12-31-08.

Bonds were sold at a price to yield 12% per year.

Book Interest Interest Unamort Book

Yr Value Received Income Amort. Disc/Prm Value

2007 96,535 5,000 5,792 792 2,673 97,326.99

2007 97,327 5,000 5,840 840 1,833 98,166.61

2008 98,167 5,000 5,890 890 943 99,056.61

2008 99,057 5,000 5,943 943 (0) 100,000

Bond IIlustration – Slide 6 of 11. On Jan. 1, 2007, issued $100,000, 10%, 2 year bonds.

Interest is paid on 6-30 and 12-31. Mature 12-31-08.

Bonds were sold at a price to yield 12% per year.

Income(DR) (DR) (CR) (DR)

Bond Bonds InterestTransaction Cash Discount Payable Expense

IssueBonds 96,535 3,465 (100,000)

PayInterest (5,000) 5,000

AmortizeDiscount (792) 792

Totals 3,465 (100,000) 5,792Book Value - bonds - 6-30-06 ($96,535)

Balance Sheet

Bond Illustration. [7 of 11]

Cash 96,535 Discount 3,465

Bonds Payable 100,000

Interest Expense 5,000 Cash 5,000

Interest Expense 792 Discount 792

Corp. Issues Bonds - 8 of 11

Issues Bonds 1-1-07

Adjusting Entry 6-30-07

Interest Payment 6-30-07

Bond Investment 96,535 Cash 96,535

Cash 5,000 Interest Revenue 5,000

Bond Investment 792 Interest Revenue 792

Bob Buys Bonds - 9 of 11

Bob Buys Bonds 1-1-07

Adjusting Entry 6-30-07

Interest Received 6-30-07

Bond IIlustration – Slide 10 of 11

How much income is recognized by Bob in first year?

Bond IIlustration – Slide 11 of 11

How much income is recognized by Bob in first year?$5,792.09 plus $5,839.62.---------------------If the company calls the bonds at a price of 100 on June 30, 2007, what is Bob’s gain or loss.

CPA Exam QuestionOn Jan. 1, 2007, Carr Corp purchased Fay Corp. 9%. 10-year bonds with a face amount of $400,000 for $375,600, to yield 10%. The bonds are dated January 1, 2007, mature on December 31, 2015, and pay interest annually on Dec. 31. Carr uses the interest method of amortizing discount. What is Carr’s interest revenue for 2007?$40,000 b. $37,560 c. $36,000 d. $34,440(Source: CPA)Ignore some rounding in the price computation

Carr CorporationAnswer is BFace value of investment $400,000Book value of investment $375,600Yield rate 10%Interest earned (revenue) $37,560Interest received

(9% of face value) $36,000Amortization of discount $1,560

In 1997, Helwett-Packard issued 20-yearbonds with a face value of one billion,eight hundred million dollars.They were zero coupon bonds.The bonds sold for $968 million.The bonds were priced to yield 3.15% compounded annually.Assume you purchased a bond witha face value of $100,000at the price indicated above.What is your interest income for 1997?What is your interest income for 1998?

Hewlett-Packard Zero Coupon Bonds - 1

Face value $1,800,000,000

Price $968,000,000

Price as % of face value 53.777778%

Cost of your bond $53,778

Yield rate 3.15%

Interest income for 1997 $1,694

Book value at end of 1997 $55,472

Interest income for 1998 $1,747

Hewlett-Packard Zero Coupon Bonds - 2

End