Held-to-Maturity (HTM) Securities - Online Tutor, Practice Problems & Exam Prep

Held to maturity investments involve purchasing bonds where the price differs from the principal due to interest rate variations. If the stated rate exceeds the market rate, bonds sell at a premium; if lower, they sell at a discount. For example, a bond with a principal of $50,000 at a 9% stated rate may sell for $54,000 if the market rate is 8%. Amortization of premiums or discounts adjusts interest revenue over the bond's life, ensuring the carrying value aligns with the principal at maturity. This process is crucial for accurate financial reporting and understanding investment valuation.

Stated Rate vs. Market Rate for Held-to-Maturity Investments

Now let's discuss held-to-maturity investments. So, I want to make a note before we dive in here: held-to-maturity investments are very similar to when we deal with bonds payable. So what I'd like you to do is compare what you learn here with held-to-maturity investments to what you learn with bonds payable because bonds payable are basically the other side of this. In this situation, we're the investor; we're the ones buying the bonds. In the other situation, we're the ones selling the bonds and we have bonds payable. Well, this is similar; we would have bonds receivable; we're having this investment. Okay? So let's go ahead and check this out.

Held-to-maturity investments, the big thing we're dealing with here is the price of the investment is going to be different than the principal amount, and that's because of the interest rates. Okay? There's a big discussion about this when we talk about bonds payable, but I'm going to go over it in a kind of quick fashion here. What causes those prices to be different is the difference between the stated rate, which is the rate that the bond itself pays. The bond itself is going to pay some interest rate, that's the stated rate, and then the rest of the market, everyone else who is selling bonds, is going to pay the market rate. Let's say the stated rate is 10% and the market rate is 10%, well then the price of the bond will be equal to fair value. Okay. So that's the situation when the stated rate and the market rate are the same; then you're selling it at face value.

Now, when there's a difference in the rates, that's when we're going to get premiums and discounts. So if the stated rate is less than the market rate, let's say you're paying 8% and the market is paying 10%, right? So, you're an investor and you're about to buy a bond, would you rather buy a bond that's paying 8% or would you rather buy a bond that's paying 10%? You'd rather buy the one that's paying 10%, right? You want to get more interest. So this one that has lower interest is going to have to be sold, the price of the bond is going to have to be less than the face value of the bond, okay? The face value of the bond is the principal amount. Let's say it's going to be a $1,000 bond, well, that would have to sell for less than $1,000 because of this low interest, so it would be sold at a discount because other bonds are more enticing than your bond.

The opposite here is if the stated rate is greater than the market rate. So if the stated rate is greater, well then the price will be greater than the face value and this is a premium, right? Because your bond is more enticing now, yours has a higher stated rate than all the other bonds on the market. People would prefer to buy yours and they'll pay more for it. Okay? So this is an overview of how you deal with interest rates. I would suggest if you're still confused with it, to go to the bonds section and that's where we're going to discuss this in a lot more detail. Here, we're going to leverage what we learned with bonds to apply it to investments. Okay? So let's go ahead and pause and then we'll deal with premium bonds first, and then deal with the discount.

Premium on Bonds Receivable

Alright, so let's deal with the premium bonds here. Notice on January 1, 2018, ABC Company purchases $50,000 of 9% bonds maturing in 5 years. Interest is payable semi-annually on January 1 and July 1. The market interest rate was equal to 8%, the bonds were issued at 108%. So notice the market rate was 8% and the bonds pay 9%. So the stated rate is 9% that these bonds are going to pay, while the market is paying 8%. So these bonds are more enticing, and they're going to sell at a premium. What does it mean they're going to sell at 108? Well, that means they're going to sell at 108% of their $50,000 principal value. So the principal of these bonds is $50,000, we are going to have to multiply it by 108%, which is 1.08, and that'll tell us what these bonds actually sold for. So let's find out what that is, $50,000 times 1.08, that comes out to $54,000. So these bonds are going to sell for $54,000 even though the principal amount is $50,000, and that's because of this extra interest that they pay. Cool?

So, when we buy these bonds, we're going to pay cash, right? We bought these bonds, so we paid cash for them of $54,000, right? We paid $54,000 in cash, and what did we receive? We have bonds receivable, right? We have bonds receivable at $50,000, so that's our investment of $50,000, but we also have the premium, right? Just like we learned with bonds payable, there's going to be this premium or this discount that makes up the difference between the cash we paid and the actual principal amount. So remember, in the bonds receivable account, just like with bonds payable, you always put the principal amount, okay? And the principal amount is this $50,000. That's the amount that will be repaid when these mature in 5 years, okay? So the $50,000 goes there, and then we're also going to increase the value of our investment with the premium on bonds, okay? So this premium on bonds is a sub-account related to the bonds that is increasing its value. When we have a discount on bonds, it's also going to be a sub-account of the bonds receivable, but it decreases the value, okay?

So when we show this on our balance sheet, we're going to show a net value of our bonds of $54,000, and as time goes on, as we get closer to the maturity date, that premium will be disappearing until we're left with just the $50,000. Okay, so we'll see how that premium disappears in our next journal entry, but let's finish this one up right here. So we had assets, our assets go up, right? Because we received bonds receivable, so we are going to receive that $50,000 in the future. And we had the premium of $4,000, but guess what? We paid for that with cash. Cash was $54,000 and that was a decrease to our assets. So all we did was buy an asset with cash. So our assets stay at the same level, we just have a different asset now. Alright? So now let's go deal with the amortization of this bond premium and our interest journal entry in the next video.

Premium on Bonds Receivable

Alright, so we had that $4,000 premium on the bonds, over the life of the bond we're going to amortize that premium into our interest revenue to get rid of it. All we want left when the principal is repaid after 5 years is just the bonds receivable amount, just the principal value. So we're going to be getting rid of the premium through our interest revenue. Let's see how this works. What we're going to use is the straight-line method for premium amortization. Now this isn't technically GAAP, but it gets a lot more complicated, so we generally just use straight-line method in this class because it's a little easier.

Here's how we do it: we take the total bond premium, which in this case was the $4,000, right? Total premium, and we have to divide it by the number of interest periods. So how many interest periods are there in this example? Well, it was 5 years, right? There are 5 years, but interest is payable semiannually, which is twice a year, January 1st and July 1st. So if it's twice a year for 5 years, that means there are 10 interest periods, right? 5 years times 2 is 10 total interest periods, so that gives us premium amortization of $400 per interest period.

Notice, this is very similar to what we do with bonds payable. It's actually exactly the same, we're just on the other side of the situation, so all our entries are just reversed. Now we have interest revenue instead of interest expense. Now we have interest receivable instead of interest payable. The cash is received instead of cash paid. Let's go ahead and see how this journal entry works out. We already know the amount of the amortization of the premium right here, $400. But let's go ahead and figure out the rest of the entry.

Let's find out how much cash is going to be received from this interest payment, and it's going to be the $50,000 of principal, right? The cash interest that this pays is based on the stated rate. When we bought this bond, they said, "Hey, we're going to pay 9% interest on $50,000 of principal, who wants to buy it?" And we bought it, $50,000 of 9% bonds, so $50,000 times 9%, which is 0.09. How much does that come out to? It comes out to $4,500, but that's annual, right? That would be the annual amount because 9% is the annual interest rate. So we need to divide it by 2, and it'll give us the semiannual $2,250, right? And that's the amount that we need in our journal entry because this is a semiannual interest payment, so they pay half of it every 6 months, $2,250.

So we know we're going to receive cash of $2,250, and we have to amortize that premium. Remember, the premium had a debit balance, right? When we look at the previous entry, the premium was increasing the value of our asset, so now we're going to be getting rid of it with credits. It had a debit balance; we get rid of it with credits, so we're going to credit the premium for the amount of the amortization. Premium on bonds, and that's going to be $400. And then what's left is our interest revenue.

We earn interest revenue from earning interest, right? Time has passed, we've earned interest and in this case, it's a plug that fills in our journal entry. We know we received cash interest of $2,250, so we received that in cash. We had to amortize the premium of $400, and we're left with interest revenue of $1,850.

Remember, the amortization of the premium, the reason we do this is because over time we're not going to receive $54,000 when this bond matures. We're only going to receive $50,000, which is the principal amount. So by amortizing this premium over the life of the bond, we're getting rid of that premium so that once the maturity date comes around all that's left on our books is the $50,000 in our bonds receivable.

In this journal entry, we received cash of $2,250. So that was an increase in our assets, but the premium, which was an asset, decreased by $400, so that's going to decrease our assets, and the interest revenue right here, interest revenue is revenue to the company and that would increase by $1,850 our equity, right, because that's going to increase our income. Now that we've seen it for premiums, let's go ahead and do the same thing for a discounted bond.

Discount on Bonds Receivable

Alright, let's examine a scenario involving a discount. On January 1, 2018, ABC Company purchases 50,000 of 9% bonds maturing in 5 years, with interest payable semi-annually. Notice that nothing has changed here, except that the market rate is now 10%. The market rate is 10% when the bonds themselves have a stated rate of 9%. This causes them to be sold at a discount. We're saying, "Hey, buy these bonds at 9% when everyone else in the market is paying 10%." So, as an investor, I am thinking, "You're only paying 9% interest, well, you're going to have to give me a discount if you want me to buy that, everyone else is paying 10% interest." They are going to be issued at 94. They have to inform you of some sort of issue price like that.

So, how do we figure out what the cash amount is? How much did we actually purchase it for? It's going to be 50,000 times 94%, that 94 is just a percentage, so 0.94. Let's find out what that comes out to be. So notice what we do here and how similar it is to the other journal entry. Our cash is still credited because we paid for this in cash. Give it some space, and we're still going to have bonds receivable, right? We have this asset for bonds receivable, and we put the entire amount of the principal balance. The whole 50,000 principal goes into the bonds receivable account, right here.

But now we're going to have the discount. The discount on bonds has to make this entry balance with a credit of 3,000. So, notice everything balances out at 50,000 debits, 50,000 credits, and we're balanced at a value for the bonds. Notice these bond discounts; it's lowering the value of the bonds down to 47,000, which is the amount of cash we paid. But in 5 years when this matures, we're not going to receive 47,000; we're going to receive 50,000, the amount of principal. That's why we keep that amount in the bonds receivable account, and then we're going to amortize the discount over the life of the bond so that it is gone by the time we receive the principal. Cool? Alright. So let’s see that amortization and the interest revenue in the next session.

Discount on Bonds Receivable

Alright, so just like we did with the premium, we're going to use the same amortization to amortize the discount. So in this case, we had a discount of 3,000 and it's being amortized over 10 periods, right over 10 periods because it's 5 years, 2 semiannual periods per year, it comes out to 10 interest periods. So that comes out to 300 of amortization per period, right. So we're gonna get rid of the discount at $300 per period over the 10 periods and that will get rid of the entire 3,000 discount. So this should say revenue, I think yours probably already says revenue. We're going to make a journal entry here, right? Because we're the ones receiving these bonds, so we're going to be receiving interest and we're going to earn interest revenue and we're going to get rid of this discount. So just like we did before, let's find the cash amount of the interest that we're gonna receive. And remember, the cash interest is gonna be paid on the principal and the stated rate. So we're gonna have 50,000 in principal, that's paying 9% interest. Remember, when they sold us the bonds, they said, hey, we're going to be paying 9% interest. We know everyone else is paying 10, but we're paying 9. 50,000 times 9% is 4,500 per year, but we have to divide that by 2 to get the semi-annual 2,250. So that's the amount of cash we're gonna receive and we already calculated the discount amortization right here, so we're ready to make our journal entry. We received cash of 2,250 and we're going to amortize the discount. Remember the discount had a credit balance in this case because we're talking about an asset and the discount is lowering the value of the asset with a credit. So the balance of the asset is a debit minus the credit. So to get rid of the discount, which has a credit balance, we need to debit it. The discount on bonds and this is where it could get confusing to students because when we're dealing with bonds payable, everything is the opposite. And we're dealing with liabilities instead of assets. Okay? So in that case, the discount would have been a debit balance and we get rid of it with credits, so that's where it starts to get confusing when you have to deal with both. But the main thing to think about is when we're dealing with an asset, discounts lower the value of an asset with a credit; when we're dealing with a liability, discounts lower the value of a liability with a debit, okay? So it's always the opposite balance when we're talking about a discount. So discount on bonds, we found the amortization to be 300 and then we've got our interest revenue, right? So we're always gonna have cash and interest revenue and then we're gonna be amortizing the discount or the premium for the last part of the journal entry and our interest revenue is our plug that makes us fit for 2,550. So that's our journal entry right there. We received cash of 2,250, we amortized the discount which was lowering the value of our assets, so now this increased the value of our asset by 300 and we had revenue. Interest revenue which goes to our income statement and increases our net income by 2,550. Cool? Alright, so remember the main reason why we're amortizing that discount or that premium is because we're going to receive a different amount than we paid for the bonds originally. Alright? So that's how we deal with held to maturity investments. We're going to be amortizing them and show them at their amortized cost when we show our balance sheet. Alright? So let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What are held-to-maturity (HTM) securities?

Held-to-maturity (HTM) securities are debt investments, such as bonds, that a company intends and is able to hold until they mature. These investments are recorded at their amortized cost on the balance sheet, which means any premiums or discounts are amortized over the life of the bond. The primary reason for holding these securities is to earn interest income over time, and they are not subject to market value fluctuations in financial reporting.

How are premiums and discounts on HTM securities amortized?

Premiums and discounts on HTM securities are amortized using methods like the straight-line method or the effective interest method. The straight-line method divides the total premium or discount by the number of interest periods, spreading the amount evenly over the bond's life. The effective interest method, which is more accurate but complex, adjusts the amortization based on the bond's carrying amount and the market interest rate. This process ensures that the carrying value of the bond aligns with its principal at maturity.

What is the difference between the stated rate and the market rate in HTM securities?

The stated rate, also known as the coupon rate, is the interest rate that the bond issuer agrees to pay on the bond's face value. The market rate, or yield, is the interest rate prevailing in the market for similar bonds. If the stated rate is higher than the market rate, the bond sells at a premium. Conversely, if the stated rate is lower than the market rate, the bond sells at a discount. These differences affect the bond's selling price and subsequent amortization.

How do you calculate the purchase price of a bond sold at a premium or discount?

To calculate the purchase price of a bond sold at a premium or discount, multiply the bond's face value by the percentage at which it is sold. For example, if a $50,000 bond is sold at 108%, the purchase price is calculated as:

$\mathrm{50,000}\times 1.08=\mathrm{54,000}$

Similarly, if the bond is sold at 94%, the purchase price is:

$\mathrm{50,000}\times 0.94=\mathrm{47,000}$

Why is amortization of premiums and discounts important in HTM securities?

Amortization of premiums and discounts is crucial for accurate financial reporting and investment valuation. It adjusts the interest revenue over the bond's life, ensuring that the carrying value of the bond aligns with its principal at maturity. This process reflects the true cost of the investment and the actual interest earned, providing a clearer picture of the company's financial health and performance.