So in this post, I’ll provide the mechanics of the issue. In my next post, I’ll provide “empirical data.”
Bond issued at a discount. Say a bond is issued for $90 and face value is $100. Say interest payments are $5 each period for five periods, and then the bond is repaid. To make it easy, do straight line “amortization” of the bond discount in the amount of $2 each period.

Wrong way--Statement of cash flows:

Year 1 financing 90 operating (5)
Year 2 financing -- operating (5)
Year 3 financing -- operating (5)
Year 4 financing -- operating (5)
Year 5 financing (100) operating (5)

Right way--Statement of cash flows:

Year 1 financing 90 operating (5)
Year 2 financing -- operating (5)
Year 3 financing -- operating (5)
Year 4 financing -- operating (5)
Year 5 financing (90) operating (15)

Bond issued at a premium. Say a bond is issued for $110 and face value is $100. Say interest payments are $5 each period for five periods, and then the bond is repaid. To make it easy, do straight line amortization of the bond premium in the amount of $2 each period.

Wrong way--Statement of cash flows:

Year 1 financing 110 operating (5)
Year 2 financing -- operating (5)
Year 3 financing -- operating (5)
Year 4 financing -- operating (5)
Year 5 financing (100) operating (5)

Right way--Statement of cash flows:

Year 1 financing 110 and (2) operating (3)
Year 2 financing (2) operating (3)
Year 3 financing (2) operating (3)
Year 4 financing (2) operating (3)
Year 5 financing (100) and (2) operating (3)

Why do most of us do it wrong? Probably because we have not thought about it hard enough (or attended Dan’s seminar). The SEC requires the "right way" approach; you would have to read through their speeches to find it, though, which is why most of don’t know about it.

Dan Gode has some really neat insights on this topic. Here's a summary of them: The term amortization makes little sense when it is applied to bonds issued at a discount. For discount bonds, one should use the term accretion while the term amortization should be reserved for premium bonds. Because of the poor terminology that we use in accounting (i.e., the amortization word for both discounts and premiums), people tend to want to treat them symmetrically. That is, they add back amortization of discount (which is correct). Using the "symmetry guide to accounting," they also subtract the amortization of the premium (which is incorrect).

For discounts, accretion of bonds should be added on the indirect format because it reflects the extent to which interest expense is not paid in cash.

For premiums, the problem is that there is no such thing as a prepaid interest. Stated differently, any payments made in excess of interest expense do not appear as prepaid interest, they reduce principal. So adding back the premium amortization on the indirect method SCF is incorrect as it puts some repayment of principal in the operating section.

Many thanks to Dan Gode for clearing this up for me!

]]>