Held to Maturity Debt Securities

Summary

This session focuses on held-to-maturity (HTM) securities, a category of debt investments. HTM is used when a company intends and is able to hold investments like bonds until they mature. Investments are accounted for at amortized cost rather than fair value, with any premium or discount amortized using the effective interest rate method. An example illustrates the process of buying an HTM bond, receiving interest payments, and the amortization schedule. The session also covers journal entries for bond purchases, interest revenue, and potential bond sales before maturity, emphasizing the importance of understanding HTM for accounting students and CPA candidates.

Takeaways

• 📈 Held-to-maturity (HTM) securities are used when a company intends and is able to hold investments, typically bonds, until they mature.
• 💼 HTM securities are accounted for at amortized cost rather than fair value, as the intent is to hold until maturity, making short-term market fluctuations irrelevant.
• 🔍 Only bonds can be classified as HTM because stocks or equity investments do not have a maturity date.
• 📊 Amortization of any premium or discount on HTM securities is done using the effective interest rate method, which is based on the bond's book value.
• 📚 The effective interest rate method is chosen for amortization because it reflects the actual yield of the investment over its life.
• 🏦 Adam Company's example illustrates the process of purchasing a discount bond, receiving interest payments, and the amortization schedule.
• 📋 The initial purchase of a bond is recorded at its cost, and an amortization schedule is prepared to track the bond's carrying value over time.
• 📝 The first journal entry for a bond includes recording the cash received from interest, the interest revenue, and the amortization of the discount.
• 📉 If a bond is sold before maturity, the carrying value is updated to determine any gain or loss on the sale, using the effective interest method.
• 💻 For accounting students and CPA candidates, the speaker recommends visiting their website for supplemental materials, including lectures, exercises, and access to AICPA questions.

Q & A

What are the three categories of debt investments discussed in the script?

The three categories of debt investments discussed are held-to-maturity, trading, and available-for-sale.

What is the definition of held-to-maturity securities?

Held-to-maturity securities are debt investments that a company intends and is able to hold until they mature, typically bonds, as they are the only debt securities that mature.

Why are held-to-maturity securities accounted for at amortized cost rather than fair value?

Held-to-maturity securities are accounted for at amortized cost because the investor intends to hold the bond until it matures, at which point they will receive the face value of the bond, regardless of market fluctuations.

How is the premium or discount on held-to-maturity securities amortized?

The premium or discount on held-to-maturity securities is amortized using the effective interest rate method, which is based on the bond's book value.

What is an example of a held-to-maturity security given in the script?

An example given is a $100,000 eight percent bond purchased for $92,278 on January 1st, 20X0, which is a discount bond because it was bought below its face value.

How often does the bond in the example pay interest, and what is the amount of the first interest payment?

The bond pays interest semi-annually, and the first interest payment is $4,000, which is calculated as $100,000 times 8% times 6/12.

What is the purpose of creating an amortization schedule for a bond?

An amortization schedule is created to track the bond's carrying value over time, showing how the premium or discount is amortized and how it affects the bond's value as it approaches maturity.

What happens to the carrying value of a held-to-maturity bond over time?

The carrying value of a held-to-maturity bond increases over time through the amortization of any premium or discount until it matches the bond's face value at maturity.

What is the process for accounting when a held-to-maturity bond is sold before maturity?

When a held-to-maturity bond is sold before maturity, the carrying value must be updated to reflect the amortization up to the sale date. Any gain or loss is then calculated based on the difference between the sale price and the updated carrying value.

What is the significance of the effective interest rate method in the amortization process?

The effective interest rate method is significant because it provides a systematic way to allocate the bond's discount or premium over its life, ensuring that the bond's carrying value reflects the time value of money.

What advice does the speaker give to accounting students or CPA candidates regarding their studies?

The speaker advises accounting students or CPA candidates to visit their website, foreheadlectures.com, for supplemental materials, lectures, and exercises to enhance their understanding of accounting concepts.

Outlines

00:00

📈 Held-to-Maturity Securities Overview

This paragraph introduces the concept of held-to-maturity (HTM) securities, which are bonds that a company intends to hold until they mature. It explains that only bonds can be classified as HTM, not stocks, because stocks do not have a maturity date. The accounting treatment for HTM securities is at amortized cost rather than fair value. This is because the value of bonds tends to fluctuate but will ultimately return to their face value at maturity. The paragraph also discusses the process of amortizing any premium or discount on HTM securities using the effective interest rate method. An example is given where Adam Company purchases a discounted bond, and the process of recording the purchase and setting up an amortization schedule is explained.

05:01

📊 Amortization Schedule and Interest Revenue

The second paragraph delves into the specifics of an amortization schedule for a bond investment. It explains how the first and second interest payments are recorded, with a focus on the difference between the cash received and the interest revenue, which is the amount to be amortized. The paragraph outlines the process of updating the bond's carrying value through periodic interest revenue calculations and amortization of the discount. It also touches on the importance of the amortization schedule in determining the gain or loss if the bond is sold before maturity. The speaker encourages students to visit their website for additional resources and to connect on social media.

10:02

💼 Journal Entries and Gains on Sale

The final paragraph discusses the journal entries that would be made for the bond investment, particularly focusing on the receipt of cash and interest revenue, as well as the accrual of interest at year-end. It also addresses the scenario where the bond is sold before maturity, explaining how the carrying value is updated to determine any gain or loss on the sale. The paragraph concludes with a call to action for accounting students and CPA candidates to visit the speaker's website for more resources and to invest in their education.

Keywords

💡Held to Maturity

Held to maturity refers to a category of debt investments where the investor has the intent and ability to hold onto the investment until it reaches its maturity date. In the script, it is explained that held to maturity securities are typically bonds, as they have a maturity date, unlike stocks. The concept is central to the video's theme as it sets the stage for discussing how such investments are accounted for and managed over time.

💡Debt Investment

Debt investment is a type of financial asset where an investor loans money to a borrower in exchange for periodic interest payments and the return of principal at a later date. In the transcript, debt investments are contrasted with equity investments and bonds payable, highlighting their role as assets on a company's balance sheet. The video discusses how these investments are accounted for when held to maturity.

💡Amortized Cost

Amortized cost is the method used to account for held to maturity securities, where the investment is recorded at its purchase price and any premium or discount is gradually recognized over the life of the investment. The script explains that this method is used because the investor expects to receive the bond's face value at maturity, making the fluctuations in market value irrelevant.

💡Effective Interest Rate Method

The effective interest rate method is a technique used to amortize premiums or discounts on bonds. It takes into account the bond's book value and the market interest rate to calculate the periodic interest revenue. The video script uses this method as an example to demonstrate how the carrying value of a bond increases over time through amortization.

💡Premium and Discount

Premium and discount refer to the price differences when a bond is bought above or below its face value, respectively. The script mentions that when a bond is purchased at a discount, like the example of Adam Company's bond, it indicates that the market interest rate is higher than the bond's coupon rate, leading to a lower purchase price.

💡Amortization Schedule

An amortization schedule is a table that shows the breakdown of bond payments into interest and principal over the life of the bond. The transcript describes how an amortization schedule is prepared for a bond, detailing the process of increasing the bond's carrying value through the amortization of the discount.

💡Interest Revenue

Interest revenue is the income earned from interest payments on a bond or other debt securities. In the script, interest revenue is calculated using the effective interest rate method and is an essential component in the accounting process for held to maturity securities.

💡Accrual Accounting

Accrual accounting is the process of recognizing revenues and expenses when they are earned or incurred, rather than when cash is exchanged. The video script mentions accrual accounting in the context of recognizing interest revenue at year-end, even though the cash payment is received in the next period.

💡Carrying Value

Carrying value refers to the net book value of an asset or liability reported on a company's balance sheet. In the transcript, the carrying value of a bond is adjusted through the amortization process, reflecting the bond's value on the company's books at a given point in time.

💡Gain or Loss on Sale

A gain or loss on sale occurs when an investment is sold for a price different from its carrying value. The script discusses how to calculate the gain if Adam Company sells its held to maturity bond before maturity, taking into account the updated carrying value and the sale price.

💡Subscription Model

The subscription model is a business strategy where customers pay a recurring fee to access content or services. The video script briefly mentions a subscription model in the context of the instructor's website, offering a month-to-month subscription without long-term contracts, which is a way to provide ongoing educational content.

Highlights

Introduction to the session discussing health to maturities category in debt investment.

Explanation of three parts of investment: held to maturity, trading, and available for sale.

Focus on held to maturity securities and their criteria for use.

Definition of held to maturity securities and their exclusion of stocks.

Accounting for held to maturity investments at amortized cost, not fair value.

Reasoning behind using amortized cost for held to maturity bonds.

Amortization of premium or discount using the effective interest rate method.

Example of Adam Company purchasing a bond to illustrate the concept.

Description of the bond as a discount bond due to purchase below face value.

Maturity of the bond in five years and semi-annual interest payments.

Accounting for the bond purchase and initial recording at cost.

Explanation of preparing an amortization schedule for bonds.

First interest payment and calculation of interest revenue.

Process of recording interest revenue and adjusting the bond's carrying value.

Repetition of the amortization process until bond maturity.

Reminder to visit the website for supplemental accounting materials.

First journal entry example for receiving cash and interest revenue.

Explanation of accruing interest revenue by year end.

Scenario of Adam Company selling its investments and accounting for it.

Calculation of gain or loss upon selling the bond before maturity.

Final encouragement to use the provided resources for accounting studies.

Transcripts

hello and welcome to the session in

which we will discuss health to

maturities category that is part of the

debt investment so if you invest in that

you could have your investment

categorized under three

parts either health to maturity

trading or available for sale and this

is what we discussed in the prior

session we gave an overview about debt

investments as well as equity investment

in this session we're going to focus on

health to maturity and we'll focus on

trading available for sale then we would

look at the equity section so what is

held to maturity securities well when is

it used well it's used when the company

has the intent and ability to hold the

investment until it mature well remember

the only thing that mature are bonds

that security so you don't have stocks

in this category okay because stocks or

equity investments don't mature now how

do we account for htm how do we account

for these investments at amortized cost

not fair value and we explain why in the

prior session because if you hold the

bond until it mature you will always get

the phase value so if you hold a bond

and the bond goes up in value and it

goes down then it goes down it goes up

then it's up down up up down at the end

it's going to come back to the face

value therefore ignore all these

fluctuation because if you're holding it

you're going to get the face value

that's the purpose and what do we do

we're going to amortize any premium or

discount using the effective interest

rate method generally speaking

why do we amortize using the effective

interest rate method because that's the

method that's based on the balance of

the bond the book value of the bond and

you might the reason is you might buy

the bond at a premium or you might buy

it at a discount just amortize it and i

hope you are familiar with premium and

discount amortization because we learn

about about how we discount bonds in the

bonds section if not please go to

forehead lectures to see how we do so

the best way to illustrate this is to

actually look at an example

adam company purchased one hundred

thousand eight percent bond of forehead

lectures january first twenty x zero

paying ninety two thousand two seventy

eight now without telling you this you

know this is a discount bond because the

bond is a hundred thousand dollar bond

you purchase it below the face value

therefore it's a discount bond

the bond matures in five years

on january 1st 20 x5 the bond yields 10

obviously because it yields 10 percent

it was sold at a discount

okay

because the interest rate the market

rate is 10 so the purchaser

adam company discounted that bond at 10

and the interest is payable

semi-annually july and january now when

you buy a bond what do you have to do

you have to account for the purchase you

have to account for the in for for any

interest received then if you sell the

bond you sell the bond you have to

account for the gain or the loss and

this is what we're going to be doing

first buying the bond well the bond now

it's a debt investment so notice i did

not mention the word bond it's a debt

investment it's an asset

okay versus

bonds payable when we sell a bond when

the company sells a bond that's a

liability two different things i mean i

mean in my in my classes always students

they debit bonds payable no you are

buying an investment you are not

reducing your liabilities when you buy a

bond and you credit cash you purchase it

for 92 000

278 this is on january 1st 20x0

and this is your cost this is how much

you paid for that bond

just any other asset when you buy it

initially you would record it at its

cost then what companies would do just

like when you issue a bond when you i

when you buy a bond you prepare an

amortization schedule and this is what

an amortization schedule looks like i'm

going to go over this amortization

schedule however if you are not familiar

with this by all means go back to my

bonds chapter and learn about bonds

well first the carrying value of the

bond when you bought the bond the

carrying value is the cost which is a

discounted bond then

six months later on july first

the bond will make its first payment you

would receive four thousand dollar in

cash why four thousand well the bond is

a hundred thousand dollar eight percent

bond pays interest semi annually well

one hundred thousand times eight percent

times six twelve the cash received is

four thousand dollar

now we need to know what's the interest

revenue the interest revenue is four

thousand six hundred and fourteen how do

we compute the interest revenue we'll

take the bond carrying value as of the

beginning of this period ninety two

thousand two seventy eight multiplied by

the market rate multiplied by one half

for six months therefore interest

revenue is four thousand six hundred and

fourteen well this is the interest

revenue

that you are going to be recording the

cash that you received only four

thousand the difference between them is

the amount you're going to be amortizing

so the difference is the amount you're

going to be amortizing which is 614

the difference between them now you're

going to take the 614 dollars and add it

to the previous carrying value and the

carrying value goes up to 92 000 894 and

this process would repeat itself well

july january 1st

second interest payment is four thousand

dollar notice the cash is always the

same

interest revenue based on the previous

carrying value times ten percent times

the market rate the difference between

them is the discount bond then the bond

carrying value will go up to ninety

three thousand five thirty seven and if

we keep going through this process until

january first twenty x five by the time

the bond matures notice it goes up it

goes back to 100 000. before we proceed

any further i would like to remind you

whether you are an accounting student or

a cpa candidate to take a look at my

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following now let's take a look at the

first journal entry that's going to take

place july 1st 20

20 x 0 which is this

period right here this period right here

well what did we do on july 1st we

received cash of 4 000

we're gonna credit interest revenue

4614 which we computed earlier the

difference will be the debt investment

so notice what we do we're going to

increase our debt investment by 604

and period after period what's going to

happen the amount that we amortize

it's going to increase our

carrying value until the carrying value

becomes 100 000. and this is what we

meant by keep your bond if it's held to

maturity at maturity

as amortized cost why because at the end

of the life of the bond you're going to

get 100 000. now on the way there it

might fluctuate but we will ignore those

fluctuation let's take a look at the

second payment that let's take that

takes place on january 1st well before

we get to january first we have december

31st as year end this is what we're

going to be assuming so by year end we

have to accrue

the 4 000 that we're going to be

receiving on january 1st we're going to

have to accrue the interest revenue of

4645 computed as the prior carrying

value times 10 percent times one-half

and the difference will be that

investment increasing our carrying value

what's reported on the financial

statement on the balance sheet we're

going to have

interest receivable right here four

thousand dollar we're going to have an

investment in bonds at 93 537 december

31st

20x0 on the income statement we're going

to report interest revenue

4614 received in cash

46.45

we accrued we accrued

right here we accrued right here

together we would report interest

revenue of nine thousand two hundred and

fifty nine dollars

what happened if adam company sell its

investments on november first twenty x

four so november first is some place in

here toward the end of the life of the

bond which is not a big deal the bond

almost

almost mature

at 99.8 percent it means 100 000 times

0.998

plus

a crude interest because the investor

would like to get the accrued interest

now the first thing we have to do if

that's the case when when we retire a

bond

we have to do we have to bring the

carrying value because the carrying

value as of july was 99 048 dollars why

do we need to do so because the carrying

value

will determine whether we have a gain or

a loss because we sold this investment

well we're going to take the carrying

value from 99 000 48 bring it to

november first carrying value how so

well we have to prorate the 600

this

952 dollars of

discount so that the amount of discount

from july to january is 952 we're going

to take this amount multiplied by 4 6

which is for july august september and

october 4 month and that's going to give

us 635

the first thing we do is we update the

carrying value of the bond we debit the

investment credit interest revenue for

6.35 so now our bond is up to date now

we can determine whether we have a gain

or a loss we sold the bond not including

the interest for 99

800 which is 100 000

times point nine nine eight

then the bond carrying value is

was july first ninety nine thousand

eighty four dollars plus six thirty five

the carrying value is ninety nine

thousand six eighty three well we sold

it for more than the carrying value for

117 dollars we have again let's

journalize the entry to determine

the full default the full picture cash

that we will receive is 102 74 417. hold

on a second we only sold it for

99 800

999 800 well we also have to receive

4 000 prorated for 612 why because when

we sell the bond remember whoever

whoever buys the bond will get the

interest well for selling the bond we

want the cash now because by the time

the bond make that makes the next

interest payment when they pay the 4 000

we no longer have the bond therefore we

want our money that accrued from july

until november 1st from july 1st to

november 1st and that's 4 000 times 46

and this is why if we take 99 800 plus

260

and that should give you the amount of

the cash we are going to be receiving

we

credit the debt investment for the full

amount of the carrying value we computed

the carrying value now we remove it and

again takes a credit we record the gain

on sale of the investment this is an

actual realized gain of 117

dollars what should you do now as an

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