Stated Rate vs. Market Rate for Held-to-Maturity Investments

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Now let's discuss held to maturity investments. So I want to make a note before we dive in here. Is that held to maturity investments is very similar to when we deal with bonds payable. So what I'd like to you to do is compare what you learn here with held to maturity investments to what you learn with bonds payable. Because bonds payable is basically the other side of this in this situation where the investor, where were the ones buying the bonds in the other situation were the ones selling the bonds? And we have bonds payable? Well this is similar, we would have like bonds receivable, we're having this investment. Okay so let's go ahead and check this out healthy maturity investments. The big thing we're dealing with here is the price of the investment is going to be different than what we what the principal amount is and that's because of the interest rates. Okay. So there's a big discussion about this when we talk about bonds payable but I'm gonna go over in a kind of a quick fashion here. So what causes those those prices to be different? Is the difference between the stated rate which is the rate that the bond itself pays. So the bond itself is gonna pay some interest rate. That's the stated rate and then the rest of the market, everyone else who's selling bonds is gonna pay the market rate. So let's say the stated rate is 10% and the market rate is 10%. Well then the price of the bond will be equal to fair value. Okay so that's the situation when the stated rate and market rate are the same. Well then you're selling it at face value, whoops. Face value. Now when there's differences in the rates, that's when we're gonna get premiums and discounts. So if the stated rate is less than the market rate, so let's say you're paying 8% and the market is paying 10%, right? So you're an investor and you're about to buy a bond. Would you rather buy a bond that's paying 8% or would you rather buy a bond that's paying 10%? You'd rather buy the one that's paying 10%. Right? You want to get more interest? So this one that has lower interest is gonna have to be sold. The price of the bond is gonna have to be less than the face value of the bond. Okay so the face value amount of the bond is the principal amount. Let's say it's gonna be $1000 bond. Well that would have to sell for less than $1000 because of this low interest. So it would it would be sold at a discount because other bonds are more enticing than your bond. The opposite here is if the stated rate is greater than the market rate. So if the stated rate is greater, well then the price will be greater than uh the face value and this is a premium. Right? Because your bond is more enticing now yours has a higher stated rate than all the other bonds on the market. People would prefer to buy yours and they'll pay more for it. Okay, so this is an overview of how you deal with the interest rates. I suggest if you're still confused with it, to go to the bonds section, and that's where we're going to discuss this in a lot more detail here, we're going to leverage what we learned with bonds to to apply it to investments. Okay, so let's go ahead and pause and then we'll deal with premium bonds first and then deal with this discount.

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Premium on Bonds Receivable

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Alright so let's deal with the premium bonds here, notice on january 1st 2018. Abc company purchase is $50,000 of 9% bonds maturing in five years interest is payable semiannually on january 1st and july 1st the market interest rate was equal to 8%. The bonds were issued at 108, So notice the market rate was eight and the bonds pay 9%. So the stated rate is 9% that these bonds are gonna pay while the market is paying 8%. So these bonds are more enticing they're going to sell at a premium. So what does it mean they're gonna sell at 108? Well that means they're going to sell at 100 and 8% of their 50,000 principal value. So the principle of these bonds is 50,000. We're gonna have to multiply it by 100 and 8% which is one point oh eight. And that will tell us what these bonds actually sold for. So let's find out what that is. 50,000 times 1.08. That comes out to 54,000. Okay so these bonds are gonna sell for 54,000 even though the principal amount is 50,000 and that's because of this um extra interest that they pay. Cool. So when we buy these bonds we're gonna pay cash, right, we we bought these bonds. So we paid cash for them. Of 54,000, right? We paid 54,000 in cash. And what did we receive? We have bonds receivable right? We have bonds receivable At at 50,000. So that's our investment of 50,000. But we also have the premium, right? Just like we learned with bonds payable, there's gonna be this premium or this discount that makes up the difference between the cash we paid and the actual principal amount. So remember in the bonds receivable account, just like with bonds payable, you always put the principal amount. Okay. And the principal amount is this 50,000? That's the amount that will be repaid when these mature in five years. Okay. So the 50,000 goes there and then we're also gonna increase the value of our investment with a premium on bonds. Okay, So this premium on bonds. It's a a sub account related to the bonds that is increasing its value when we have a discount on bonds. It's also going to be a sub account of the bonds receivable but it decreases the value. Okay, So when we show this on our on our balance sheet, We're gonna show a net value of our bonds of 54,000. And as time goes on as we get closer to the maturity date, that premium will be disappearing until we're left with just the 50,000. Okay, so we'll see how that premium disappears in our next journal entry. But let's finish this one up right here. So we had assets, our assets go up, right? Because we we received bonds receivable. So we have we're gonna receive that 50,000 in the future, and we had the premium Of 4000. But guess what? We paid for that with cash cash was 54,000 and that was a decrease to our assets. So all we did was buy an asset with cash. So our assets stay at the same level. We just have a different asset now. Alright, so now let's go deal with the amortization of this bond premium and our interest, our interest journal entry in the next video.

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Premium on Bonds Receivable

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Alright. So we had that $4,000 premium on the bonds over the life of the bond. We're gonna advertise that premium into our interest revenue to get rid of it. All we want left when the principal is repaid after five years is just the bonds receivable amount, just the principal value. So we're gonna be getting rid of the premium through our interest revenue. So let's see how this works. What we're gonna use is the straight line method for premium amortization. Now this isn't technically gap but it's it gets a lot more complicated. So we generally just use straight line method in this class because it's a little easier. Okay? So what we do is we take the total bond premium which in this case was the $4,000 right total premium. And we have to divide it by the number of interest periods. So how many interest periods are there in this example? Well it was five years, right? There's five years but interest is payable semiannually which is twice a year january 1st and july 1st. So if it's twice a year for five years, that means there's 10 interest periods right? Five years, times two is 10 total interest periods. So that gives us premium amortization of $400 per interest period. Okay. Now notice this is very similar to what we do with bonds payable. It's actually exactly the same. We're just on the other side of the situation. So all our entries are just reversed. Right now we have interest revenue instead of interest expense. Now we have interest receivable instead of interest payable, right? The cash is received instead of cash paid, everything is just reversed. So let's go ahead and see how this journal entry works out. We already know the amount of the amortization of the premium right here. $400. But let's go ahead and figure out the rest of the entry. Let's find out how much cash is going to be received. And from this interest payment. And it's gonna be the $50,000 of principle right? The cash interest that this pays is based on the stated rate when we sold when the when we bought this bond, they said, hey we're gonna pay 9% interest on $50,000 of principle. Who wants to buy it? And we bought it $50,000 of 9% bonds. So 50,000 times 9%. Which is 0.9. How much does that come out to? It comes up to 4500. But that's annual. Right? That would be the annual amount because 9% is the annual interest rate. So we need to divide it by two and it'll give us the the semiannual, 2250 semiannual. Right? And that's the amount that we need in our journal entry because this is a semiannual interest payment. So they pay half of it every six months, 2250. Okay? So we know we're gonna receive cash of 2250 and we have to advertise that premium. Remember the premium had a debit balance right when we look in the previous entry, the premium was increasing the value of our asset. So now we're gonna be getting rid of it with credits. It had a debit balance, we get rid of it with credits. So we're going to credit the premium for the amount of the amortization premium on bonds. And that's gonna be 400. And then what's left is our interest revenue. Okay. So we earn interest revenue from earning interest right time has passed. We've earned interest and in this case it's a plug that fills in our general journal entry. We know we we received cash interest of 2250. So we received that in cash. We have to advertise the premium of 400 And we're left with interest revenue of 1850. Okay. So remember this amortization of the premium. The reason we do this is because over time we're not gonna receive 54,000 when this bond matures, we're only gonna receive 50,000 which is the principal amount. So by advertising this premium over the life of the bond, we're getting rid of that premium. So that once the maturity date comes around all that's left on our books is the 50,000 in our In our bonds receivable. Cool. So in this journal entry we received cash of 20-50. So that was an increase to our assets. But the premium, which was an asset decreased by 400. So that's gonna decrease our assets and the interest revenue right here behind me. Interest revenue is revenue to the company. And that would increase by 1850 our equity, right? Because that's gonna increase our income. Cool. So now that we've seen it for premiums, let's go ahead and do the same thing for a discounted bond.

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Discount on Bonds Receivable

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Alright, let's see the same example. But for a discount on january 1st 2018 abc company purchases 50,000 of 9% bonds maturing in five years. The interest is payable semiannually. So no notice nothing has changed here except that the market rate is now 10% right? The market rate is 10% when the bonds self have a stated rate of 9%. So this causes it to be sold at a discount. Right? We're saying, Hey, buy these bonds that are 9% when everyone else on the market is selling 10%. So me as an investor is thinking you're only paying 9% interest. Well, you're gonna have to give me a discount if you want me to buy that. Everyone else is paying 10% interest. So they're gonna be issued at 94. They're gonna have to tell you some sort of issue price like that. Okay, so how do we figure out what the cash amount is? How much did we actually purchase it for? It's gonna be the 50,000 times 94%. That 94 is just a percentage. So 0.94. So let's find out what that comes out to be 50,000 times 0.94. It equals 47,000. So that's the amount of cash we paid for this investment. Okay, so notice what we do here and how similar it is to the other journal entry. Our cash is still credit because we paid for this in cash, give it some space And we're still gonna have bonds receivable, right? We have this asset for bonds receivable and we put the entire amount of the principal balance, the whole 50,000 principal goes into the bonds receivable account 50,000 right here. Okay. But now we're gonna have the discount. The discount on bonds has to has to uh Make this entry balance with a credit of 3000. So notice everything balances out at at 50,000 debits 50,000 credits and were balanced at at a value uh for for the bonds notice these bonds discount, it's lowering the value of the bonds down to 47,000, which is the amount of cash we paid. But in five years when this matures we're not gonna receive 47,000, we're gonna receive 50,000. The amount of principle. That's why we keep that amount in the bonds receivable account and then we're going to advertise the discount over the life of the bond so that it's gone by the time that we receive the principal. Cool. Alright. So let's see that amortization and the interest revenue in the next year.

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Discount on Bonds Receivable

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Alright, so just like we did with the premium, we're gonna use the same amortization to advertise the discount. So in this case we had a discount of 3000 And it's being advertised over 10 periods, right over 10 periods because it's 55 years to semiannual periods per year. It comes out to 10 interest periods. So that comes out to 300 of amortization. Yeah, Per period. Right? So we're going to get rid of the discount at at $300 per period over the 10 periods and that will get rid of the entire 3000 discount. So this should say revenue, I think yours probably already says revenue. Uh we're gonna make a journal entry here, right? Because we're the ones receiving these bonds, so we're gonna be receiving interest and we're gonna earn interest revenue and we're gonna get rid of this discount. So just like we did before, let's find the cash amount of the revenue that we're cash amount of the interest that we're going to receive. And remember the cash interest is going to be paid on the principle and the stated rate. So we're gonna have 50,000 in principle that's paying 9% interest. Remember when we, when they sold us the bonds, they said, hey, we're paying 9% interest, we know everyone else is paying 10 but we're paying 9 50,000 times 9% is 4500 per year. But we have to divide that by two to get the semiannual, 2250. So that's the amount of cash we're going to receive and we already calculated the premium. Amortization. Excuse me discount amortization right here. So we're ready to make our journal entry, we received cash of 2250 and we're gonna amortize the discount. Remember the discount had a credit balance in this case because we're talking about an asset and the discount is lowering the value of the asset with a credit. So the balance of the asset is a debit minus the credit. So to get rid of the discount which has a credit balance, we need to debit the discount on bonds. And this is where it can get confusing to students because when we're dealing with bonds payable, everything is the opposite and we're dealing with liabilities instead of assets. Okay so in that case the discount would have been a debit balance and we'd get rid of it with credits. So that's where it starts to get confusing. You have to deal with both. But the main thing to think about is when we're dealing with an asset, discounts lower the value of an asset with a credit when we're dealing with a liability, well discounts lower the value of a liability with a debit. Okay, so it's always the opposite balance. When we're talking about a discount. So discount on bonds, we found the amortization to be 300 and then we've got our interest revenue right? So we're always gonna have cash and interest revenue and then we're gonna be advertising the discount or the premium for the last part of the journal entry and our interest revenue is our plug that makes us fit for 2550. So that's our journal entry right there. We received cash of 2250 we advertise the discount which was lowering the value of our assets. So now this increased the value of our asset by 300 and we had interest revenue, Interest revenue which goes to our income statement and increases our net income by 2550. Cool. Alright. So remember the main reason why we're advertising that discount or that premium is because we're gonna receive a different amount than we paid for the bonds originally. Alright. So that's how we deal with held to maturity investments. We're gonna be advertising them and show them at their advertised cost when we when we show our balance sheet. Alright, so let's go ahead and move on to the next video