ACCOUNTING FOR BONDS

Accounting and financial reporting considerations for bonds can be classified into three categories:

  • the original issuance of bonds,
  • the recognition of interest expense, and
  • the accounting for bond retirements or conversions.

A bond is a formal document, usually issued in denominations of $1,000. Bond prices, both when the bonds are issued and later when they are bought and sold in the market, are expressed as a percentage of the bond’s face amount —the principal amount printed on the face of the bond. A $1,000 face amount bond that has a market value of $1,000 is priced at 100. (This means 100 percent; usually the term percent is neither written nor stated.) A $1,000 bond trading at 102.5 can be purchased for $1,025; such a bond priced at 96 has a market value of $960. When a bond has a market value greater than its face amount, it is trading at a premium; the amount of the bond premium is the excess of its market value over its face amount. A bond discount is the excess of the face amount over market value.

Bonds are long-term lending agreements between the issuing company (borrower) and the bondholder (lender). The contract between the issuer of the bonds and the bondholders is the bond indenture, and it is frequently administered by a third party, the trustee of bonds — often a bank trust department. Many bonds are traded in highly regulated public securities markets such as the New York Bond Exchange. As with most lending arrangements, bonds essentially represent an exchange of cash flows between the parties—bondholders provide a lump sum of cash in exchange for periodic (usually semiannual) fixed-rate interest payments throughout the term of the bond and the return of principal at the bond’s maturity. Bond prices vary over time and are influenced by the creditworthiness of the issuing company as well as broad economic factors affecting the overall economy, especially interest rates. What happens to the value of a bond as market interest rates rise? As interest (discount) rates increase, the present value of the future cash flows decreases, which is to say that bond prices fall as market interest rates rise. The opposite is true when market interest rates fall—bond prices rise.

Because of the mechanics involved in a bond issue, there is usually a time lag between the establishment of the interest rate to be printed on the face of the bond and the actual issue date. During this time lag, market interest rates will fluctuate and the market rate on the issue date probably will differ from the stated rate (or coupon rate) used to calculate interest payments to bondholders. This difference in interest rates causes the proceeds (cash received) from the sale of the bonds to be more or less than the face amount; the bonds are issued at a premium or discount, respectively.

ORIGINAL ISSUANCE OF BONDS PAYABLE.

If a bond is issued at its face amount, the effect on the financial statements is straightforward:

Balance Sheet Effect

Income Statement Effect

Assets = Liabilities + Stockholders’ equity

Net income = Revenues - Expenses

Increase in Cash (Asset) = Same Increase in Bonds  Payable Liability (Liability) + No change in Stockholders’ equity

No effect on Income Statement on the date of issuance

 

The journal entry is:

Dr. Cash 

               Cr. Bonds Payable

XX

 

XX

Issuance of bonds at face amount.

 

The bonds payable liability is reported at the present value of amounts to be paid in the future with respect to the bonds, dis-counted at the return on investment desired by the lender (bondholder). For example, assume that a 10 percent bond with a 10-year maturity is issued to investors who de-sire a 10 percent return on their investment. The issuer of the bonds provides two cash flow components to the investors in the bonds: the annual interest payments and the payment of principal at maturity. Note that the interest cash flow is an annuity because the same amount is paid each period. The  present  value  of  the  liability  is  the  sum  of  the  discounted  principal  and  interest  payments.

 

RECOGNITION OF INTEREST EXPENSE ON BONDS PAYABLE.  

Because bond premium or discount arises from a difference between the bond’s stated interest rate and the market interest rate, it should follow that the premium or discount will affect the issuing firm’s interest expense. Bond discount really represents additional interest expense to be recognized over the life of the bonds. The interest that will be paid (based on the stated rate) is less than the interest that would be paid if it were based on the market rate at the date the bonds were issued. Bond discount is a deferred charge that is amortized to interest expense over the life of the bond. The amortization increases interest expense over the amount actually paid to bondholders. Bond discount is classified in the balance sheet as a contra account to the Bonds Payable liability. Bond premium is a deferred credit that is amortized to interest expense, and its effect is to reduce interest expense below the amount actually paid to bondholders. Bond premium is classified in the balance sheet as an addition to the Bonds Payable liability. Whether a bond is issued at a premium or a discount, the bond’s carrying value will converge to its face amount over the life of the bond as the premium or discount is amortized.

The financial statement effects of recording the interest accrual, interest payment, and discount or premium amortization are as follows:

 

Balance Sheet Effect

Income Statement Effect

Assets = Liabilities + Stockholders’ equity

Net income = Revenues – Expenses

Interest Accrual

No Change in Assets= Increase in Liabilities (Interest Payable) + No Change in Equity

 

Interest Payment

Decrease in Assets (cash)=Decrease in Liabilities (Interest Payable)+No Change in Equity

 

Amortization

Discount

No Change in Assets = Increase in Liabilities (Discount on Bonds Payable)+ No Change in Equity

 

Premium

No Change in Assets=Decrease in Liabilities (Premium in Bonds Payable)+No Change in Equity

                                           -Increase in Interest Expense

 

 

 

 

 

 

 

 

 

                                                  -Increase in Interest Expense

 

 

 

                                                  +Decrease in Interest Expense

 

 

 

 

These entries to record the financial statement effects are as follows:

Dr. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cr. Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest accrual (each fiscal period, perhaps monthly).

 

Xx

 

 

 

Xx

 

 

 

xx

 

 

 

xx

 

 

Xx

 

 

 

Xx

 

 

 

Xx

 

 

 

Xx

 

Dr. Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest payment (periodically, perhaps semiannually).

 

Dr. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cr. Discount on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . .

Amortization of discount (each time interest is accrued).

 

Dr. Premium on Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cr. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Amortization of premium (each time interest is accrued).

 

Retirements and conversions of bonds payable.

Bonds payable are reported on the balance sheet at their carrying value. Sometimes this amount is referred to as the book value of the bonds. As discount is amortized over the life of a bond, the carrying value of the bond increases. At the maturity date, the bond’s carrying value is equal to its face amount because the bond discount has been fully amortized. Likewise, as premium is amortized, the carrying value of the bond decreases until it equals the face amount at maturity. Thus, when bonds are paid off (or retired) at maturity, the effect on the financial statements is:

 

Balance Sheet Effect

Income Statement Effect

Assets = Liabilities + Stockholders’ equity

Net income = Revenues - Expenses

Decrease in Cash (Asset) = Same decrease in Bonds  Payable Liability (Liability)

 

 

The entry is as follows.

Dr. Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cr. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

xx

 

xx

 

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