CFM23070 - Accounting for corporate finance: UK GAAP before 1 January 2005: borrowers: accrual accounting: discounted securities

Accounting for discounted securities

A discounted security is one acquired at a discount to par/its nominal value. The same accounting applies to debt which is issued at face value and redeemable at a premium. The cost to the borrower comprises the interest paid on the bond plus the difference between the issue price and the redemption price.

For example, Ghostie Ltd issues a bond with a nominal value of £100m for £80m. The bond pays interest at 2%. The bond is redeemable at nominal value after 5 years. The total cost to Ghostie Ltd of issuing this bond is £30m: £10m of interest, (£100m x 2% x 5 years) plus £20m discount, which is equivalent to a total finance charge rate of 6.9%.

Ghostie Ltd will initially record the loan at £80m. During the first year interest payable of £2m will be paid. In addition the carrying value of the loan will be increased to £83.5m in the balance sheet. The total cost to the borrower is the £2m interest plus the £3.5m increase in the carrying value of the bond. This £5.5m is the charge to the P&L and represents a cost of 6.9% on the opening carrying value of £80m.

In year 2 interest of £2m will be paid. In addition the carrying value of the loan will increase by £3.7m to £87.2m. This gives a total cost of £5.7m, which is the P&L charge, representing a cost of 6.9% on the opening carrying value of £83.5m.

This method of accounting is repeated for each of the next 3 years with the carrying value of the bond reaching £100m when it is redeemed at the end of year 5.