Chapter 4A Income- Exclusions Bonds and Original Issue Discount Edited September 14, 2008.

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Presentation transcript:

Chapter 4A Income- Exclusions Bonds and Original Issue Discount Edited September 14, 2008

Original Issue Discount. Pg. 114 Some debt instruments are issued at prices below their maturity values This original issue discount (OID) is effectively interest paid at maturity rather than periodically over the debt instrument’s life Both cash and accrual basis taxpayers recognize OID income as it accrues – Exception: Series EE bonds

Market Discount. Bonds purchased after issue in the open or secondary market at a price below maturity value. – Excess of redemption proceeds over cost is recognized as ordinary income in year of redemption. – Electively, market discount can be accrued as interest income over life of bond.

Bond IIlustration – Slide 1 of 11 On , issue $100,000 of bonds. On the bonds will mature. Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. On , Bob buys the bonds from the Corp. at a price to yield 12% (semi-annual compounding). Compute price paid by Bob by discounting cash flows at 6% per interest period.

Bond IIlustration – Slide 4 of 11 Prepare amortization table. Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables (because of rounding in the tables).

Bond IIlustration – Slide 10 of 11 How much income is recognized by Bob in first year?

Bond IIlustration – Slide 11 of 11 How much income is recognized by Bob in first year? $5, plus $5, If the company calls the bonds at a price of 100 on June 30, 2007, what is Bob’s gain or loss.

CPA Exam Question On Jan. 1, 2007, Carr Corp purchased Fay Corp. 9%. 10- year bonds with a face amount of $400,000 for $375,600, to yield 10%. The bonds are dated January 1, 2007, mature on December 31, 2015, and pay interest annually on Dec. 31. Carr uses the interest method of amortizing discount. What is Carr’s interest revenue for 2007? $40,000 b. $37,560 c. $36,000 d. $34,440 (Source: CPA) Ignore some rounding in the price computation

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