Bonds are an important part of accounting 102 and give a strong basis for future finance classes as well. Bonds are a liability for the corporation that issues them therefore they are called bonds payable. Bonds can be sold in three different ways: at a premium, at a discount, or at par. The three differ in respect to the relation between face rate and market rate. Face rate is the interest rate that is seen on the ‘face’ of the bond. Face rate does not change but market rates does and thus the difference between the two creates more accounting.
Suppose face rate is less than market rate:
If you are a customer and are in the market to invest, you would want to go with whatever investment gives you the highest return. If you have the option of buying between a bond with a face rate of 5% and a bond in the market for 6%, then you would pick the latter. A company that issued a bond at 5% would then sell their bond at a discount (i.e., sell $100 bond at $95) to compensate for the lower return on investment.
Suppose face rate is greater than market rate:
If you are a customer and are in the market to invest, you would want to go with whatever investment gives you the highest return. If you have the option of buying between a bond with a face rate of 6% and a bond in the market for 5%, then you would pick the former. A company that issued a bond at 6% would then sell their bond at a premium (i.e., sell $100 bond at $105) to compensate for the the higher return on investment.
Suppose face rate is equal to market rate:
Then there is no discount or premium and we don’t have to find the present value of the bond.
Extra: Keep in mind that a discount is not better than a premium or vice versa. This is just a way for a company to adjust for differences between face rate and market rate. By the end of the life of the bond, discounts are added to the value of interest payable which gives us total interest expense. Premiums on the other hand are subtracted from total interest payable to give us total interest expense. And finally, if face rate = market rate then interest expense is equal to interest payable (this is uncommon).
A corporation can incorporate in any state they choose. For the initial public offering, shares have to be authorized by the state before they can be issued. Since this a lengthy and expensive process (legal fees etc.), corporations authorize as many shares as possible. This allows a corporation to ‘pull’ from the authorized shares and issue however they see fit. At a future date, the corporation can issue more stock since they already have it authorized. Issuing unauthorized stock is illegal.