Question

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A company classifies its investments in long-term bonds as held-to-maturity. For each of the following independent situations, select the appropriate answer from the option list provided. Each choice may be used once, more than once, or not at all.

Choices:

The same as the face amount of the bond

More than the face amount of the bond

Less than the face amount of the bond

Situations	Answer
1. A company purchased a bond on its issue date. On that date, the bond’s stated rate is equal to the current market rate. The purchase price of the bond is
2. A company purchased a bond between interest dates. On that date, the bond’s stated rate is equal to the current market rate. The purchase price of the bond is
3. On January 1, Year 1, a company purchased a 10-year bond at a discount. The carrying amount of the bond in the company’s December 31, Year 9, balance sheet is
4. On January 1, Year 1, a company purchased a 5-year bond for its face amount. The stated rate on the bond is 10%. At the end of Year 3, the market interest rate has unexpectedly decreased to 3%. The carrying amount of the bond in the company’s December 31, Year 3, balance sheet is
5. A company purchased a bond between interest dates at a discount. At the purchase date, the carrying amount of the bond is

Answer 1

Explanation:

1. A company purchased a bond on its issue date. On that date, the bond's stated rate is equal to the current market rate. The purchase price of the bond is The same as the face amount of the bond (because coupon rate = market rate) 2. A company purchased a bond between interest dates. On that date, the bonds stated rate is equal to the current market rate. The purchase price of the bond is The same as the face amount of the bond (because coupon rate = market rate) 3. On January 1, Year 1, a company purchased a 10-year bond at a discount. The carrying amount of the bond in the company's December 31, Year 9, balance sheet is The same as the face amount of the bond (because final installment of discount on the bond would have been amortized as it matures next day on January 1, Year 10) 4. On January 1, Year 1, a company purchased a 5-year bond for its face amount. The stated rate on the bond is 10%. At the end of Year 3, the market interest rate has unexpectedly decreased to 3%. The carrying amount of the bond in the company's December 31, Year 3, balance sheet is More than the face amount of the bond (Assuming that the bonds are of trading or available-for-sale type so that decrease in market rate will increase bond's carrying amount.) 5. A company purchased a bond between interest dates at a discount. At the purchase date, the carrying amount of the bond is Less than the face amount of the bond (because bonds purchased at discount means that price paid is less than bond's face amount)

--> There exists inverse relation exists between bond price and bond's expected reinvestment rate (= market interest rate) per period. --> If the yield to maturity is lower than coupon rate, bonds will be issued at premium (bond's market price more than bond's par value) as the bonds will be demanded more among the investors; For example, if coupon rate is 10% whereas the yield to maturity is 9%, bonds will be issued at price higher than bond's par value, that is at premium. Mathematically, as bond price is calculated by discounting future coupon receipts and maturity receipt using market interest rate as the discount rate, when market interest rate is less, bond price will be more and so bonds will be issued at premium. That is, bond issuer will collect cash less than face value of bonds payable issued. --> Bond's yield to maturity is nothing but the market interest rate or expected return on bond by investors. If the yield to maturity is higher than coupon rate, bonds will be issued at discount (market price less than bond's par value) to attract more investors; For example, if coupon rate is 10% whereas the yield to maturity is 14%, bonds will be issued at price less than bond's par value, that is at discount. Mathematically, as bond price is calculated by discounting future coupon receipts and maturity receipt using market interest rate as the discount rate, when market interest rate is more, bond price will be less and so bonds will be issued at discount. That is, bond issuer will collect cash less than face value of bonds payable issued. --> If yield to maturity is equal to coupon rate, bonds will be issued at par obviously as both coupon rate and investor's expected return rate are equal which implies that bond's coupon rate exactly satisfies investors' expected return on such bonds. Mathematically, as bond price is calculated by discounting future coupon receipts and maturity receipt using market interest rate as the discount rate, if market interest rate is equal to coupon rate, it is obvious that present value of future cash flows will be equal to initial cash flow in year-0. Here, bond price is the present cash flow in year-O and future coupon receipts are future cash flows which shall be discounted to current worth using market interest rate as the discount rate.

Investments are assets (stocks) purchased by firm for holding them for investment purpose instead of intending to use them for firm's business activities. Based on purpose for which investments are purchased, they shall be classified as either "Held-to-Maturity" investments or "Trading investments" or "Available-for-sale" investments. When an investment is purchased with the objective of holding that for trading anytime, it shall be classified as either "Trading" or "Available-for-sale" investment and it shall be recorded at fair value as on date of purchasing the same by the firm. At the end of each reporting period, fair value adjustment is also done on carrying value of this type of invesment in order to update the accounting records to reflect "Trading" or "Available-for-sale" investment' fair value as the updated carrying value on balance sheet but it must be recognized as an unrealized gain (loss). Out of the three investment securities discussed above, both "Trading" and "Available-for-sale" investments are to be reported at fair value as at last day of the reporting period on balance sheet. However, unrealized gain or loss on "Trading" investments shall be recognized as income or expense on firm's income statement for the period but gain or loss on "Available-for-sale" investments are to be reported as "Other comprehensive income or loss" in the equity block till the time such investments are sold-off.