Held-to-Maturity (HTM) Securities: Videos & Practice Problems

Held to maturity investments are financial assets that an investor intends to hold until they mature, similar to bonds payable, which represent the issuer's obligation to pay back borrowed funds. In this context, when you purchase bonds, you hold bonds receivable, reflecting your investment in these financial instruments.

The price of held to maturity investments often differs from their principal amount due to fluctuations in interest rates. This discrepancy arises from the comparison between the stated interest rate of the bond and the prevailing market interest rate. The stated rate is the interest rate that the bond itself pays, while the market rate reflects the current rates offered by other bonds in the market.

When the stated rate equals the market rate, the bond sells at its face value. For example, if both rates are 10%, the bond's price will match its principal amount. However, when the rates diverge, the bond may sell at a premium or a discount. If the stated rate is lower than the market rate, such as an 8% bond in a market where the rate is 10%, the bond will sell at a discount. Investors will prefer the higher-yielding bonds, leading to a lower price for the bond with the lower interest rate.

Conversely, if the stated rate is higher than the market rate, the bond will sell at a premium. For instance, a bond with a stated rate of 12% in a market where the rate is 10% will attract buyers willing to pay more than the face value, as it offers a more attractive return.

Understanding these dynamics is crucial for evaluating held to maturity investments. The relationship between stated rates and market rates directly influences the pricing of bonds, impacting investment decisions. For a deeper understanding, it is beneficial to explore the bonds section, where these concepts are discussed in greater detail, allowing for a comprehensive application of this knowledge to investments.

When ABC Company purchased $50,000 of 9% bonds on January 1, 2018, the bonds were sold at a premium due to the stated interest rate being higher than the market interest rate. The market rate was 8%, while the bonds offered a 9% return, making them more attractive to investors. As a result, the bonds were issued at 108% of their principal value.

To determine the purchase price of the bonds, we calculate 108% of the principal amount:

\[\text{Purchase Price} = \text{Principal} \times \text{Issue Price} = 50,000 \times 1.08 = 54,000\]

This means ABC Company paid $54,000 in cash for the bonds, which consists of the $50,000 principal and a $4,000 premium. In accounting terms, the bonds receivable is recorded at the principal amount of $50,000, while the premium on bonds is recorded as a separate sub-account, reflecting the additional value of the investment.

On the balance sheet, the total value of the bonds is shown as $54,000, which is the sum of the bonds receivable and the premium. As the bonds approach maturity, the premium will amortize, decreasing in value until only the principal amount of $50,000 remains. This amortization process will be addressed in future entries.

In summary, the transaction results in an increase in assets due to the bonds receivable and the premium, while cash decreases by the same amount, keeping the total asset value unchanged. This illustrates the concept of asset exchange, where one asset (cash) is converted into another (bonds receivable and premium).

When dealing with bonds, understanding the amortization of premiums is crucial for accurately reflecting interest revenue over the life of the bond. In this scenario, we have a bond with a premium of $4,000 that we will amortize using the straight-line method. Although this method is not technically in accordance with Generally Accepted Accounting Principles (GAAP), it simplifies calculations for educational purposes.

The first step in the amortization process is to determine the number of interest periods. In this case, the bond has a term of 5 years, with interest payments made semi-annually. Therefore, the total number of interest periods is calculated as follows:

Number of Interest Periods = Years × Payments per Year = 5 × 2 = 10

Next, we divide the total bond premium by the number of interest periods to find the premium amortization per period:

Premium Amortization per Period = Total Premium / Number of Interest Periods = $4,000 / 10 = $400

Now, we need to calculate the cash received from interest payments. The bond has a principal value of $50,000 and a stated interest rate of 9%. The annual interest payment is calculated as:

Annual Interest Payment = Principal × Interest Rate = $50,000 × 0.09 = $4,500

Since interest is paid semi-annually, we divide this amount by 2 to find the semiannual interest payment:

Semiannual Interest Payment = Annual Interest Payment / 2 = $4,500 / 2 = $2,250

With these figures, we can now prepare the journal entry for the interest payment. The cash received is $2,250, and we will amortize the premium by $400. The journal entry will reflect the following:

• Debit Cash: $2,250
• Credit Premium on Bonds: $400
• Credit Interest Revenue: $1,850

The interest revenue is calculated by taking the cash received and subtracting the premium amortization:

Interest Revenue = Cash Received - Premium Amortization = $2,250 - $400 = $1,850

This process ensures that by the time the bond matures, the only amount remaining on the books will be the principal value of $50,000. The amortization of the premium effectively reduces the carrying amount of the bond, aligning it with the actual cash flow expected at maturity.

In summary, the amortization of the bond premium impacts the financial statements by increasing cash and interest revenue while decreasing the premium on bonds. This reflects a more accurate representation of the company's financial position over the life of the bond.

When a company issues bonds, the relationship between the stated interest rate and the market interest rate determines whether the bonds are sold at a premium or a discount. In this scenario, ABC Company purchases $50,000 of 9% bonds that mature in 5 years, with interest payable semi-annually. However, the market rate is 10%, which is higher than the bond's stated rate. This discrepancy leads to the bonds being sold at a discount, as investors will demand a lower purchase price to compensate for the lower interest payments.

The bonds are issued at an issue price of 94% of their face value. To calculate the cash amount paid for the bonds, multiply the face value by the issue price percentage:

Cash Paid = Face Value × Issue Price Percentage = $50,000 × 0.94 = $47,000.

In accounting terms, the journal entry reflects this transaction. The cash account is credited because the company pays cash for the bonds. The bonds receivable account is debited for the full face value of the bonds, which is $50,000. Additionally, a discount on bonds payable is recorded to balance the entry, which in this case amounts to $3,000. This discount represents the difference between the face value and the cash paid:

Discount on Bonds Payable = Face Value - Cash Paid = $50,000 - $47,000 = $3,000.

Thus, the journal entry will show:

• Debit Bonds Receivable: $50,000
• Credit Cash: $47,000
• Credit Discount on Bonds Payable: $3,000

This entry ensures that the total debits equal the total credits, maintaining the accounting equation's balance. Over the life of the bond, the discount will be amortized, gradually increasing the interest revenue recognized until the bond matures, at which point the company will receive the full principal amount of $50,000.

When dealing with bonds issued at a discount, it's essential to understand how to amortize that discount over the life of the bond. In this scenario, a discount of $3,000 is amortized over 10 periods, corresponding to 5 years with 2 semiannual periods each year. This results in an amortization of $300 per period, effectively eliminating the entire discount by the end of the term.

As the bondholder, you will receive interest revenue, which is calculated based on the principal amount and the stated interest rate. For a bond with a principal of $50,000 and a stated interest rate of 9%, the annual interest payment is $4,500. Since the interest is paid semiannually, this amount is divided by 2, resulting in a cash interest payment of $2,250 per period.

In the journal entry, you will record the cash received, the amortization of the discount, and the interest revenue. The cash entry reflects the interest payment of $2,250. The discount on bonds, which reduces the asset's value, is amortized by debiting it, thereby increasing the asset's value by $300. The interest revenue, which contributes to net income, is recorded as a plug figure, totaling $2,550 for the period.

It's crucial to note that the treatment of discounts differs depending on whether you are dealing with assets or liabilities. For assets, discounts lower the value and are recorded as credits, while for liabilities, they increase the value and are recorded as debits. This distinction is vital for accurate financial reporting.

Ultimately, the purpose of amortizing the discount or premium is to align the cash flows received with the original cost of the bonds, ensuring that the bonds are reported at their amortized cost on the balance sheet. This approach is particularly relevant for held-to-maturity investments.