Accounting for Bonds
Definition
Bonds Payable is the promissory note which the company uses to raise funds from the investor. Company sells bonds to the investors and promise to pay the annual interest plus principal on the maturity date. It is the long term debt which issues by the company, government, and other entities. It must be classified as long-term liability unless it going to mature within a year.
Each bond has a different value, term, and interest rate depending on bond indenture. The company promises to pay interest on annual or semi-annual while the principal will be paid on the maturity date. In order to understand more, please check the key terms below:
- Principal, Nominal, face, or par value: is the redemption value which states on each bond. Investor expected to receive this amount at the maturity date. This value does not take into account the present value of money, inflation, or the current market price.
- Coupon rate: is the interest rate which issuer promise to pay to their investor, it can be lower or higher than the market rate.
- Maturity date: is the date which the issuer obligates to pay back the principal amount.
- Effective interest rate: is the investor’s yield to maturity date also known as the market interest rate. We will use this rate to discount the future cash flow to the present value.
- Issuer: is the company who issue (sell) the bonds to the market to raise fund. It is the company who borrow the money and promise to pay back principal and interest.
- Holder or investors: is the person or company who buys the bonds in exchange for annual interest and principle at the maturity date.
In simple words, bonds are the contracts between lender and borrower, the amount of contract depends on the face value. However, the lender can receive the principal before the maturity date by selling contract to the capital market. The borrower will pay back the principal to whoever holds the contract on maturity date.
Bond Carrying Amount
Bonds Payable usually equal to Bonds carry amount unless there is discounted or premium. Bonds Payable equal to bonds par value.
| Bonds Carrying Amount = Bonds Payable +/- Unamortized premium/Discounted |
Amortized Bonds Payable
When the bonds issue at premium or discount, there will be a different balance between par value and cash received. The difference is premium/discount on bonds payable, which will impact the bonds carrying value presented in the balance sheet.
This amount must be amortized over the life of bonds, it is the balancing figure between interest expense and interest paid to investors (Please see the example below). At the maturity date, bonds carry amount must be equal to bonds par value.
Journal Entry for Bonds
Bond Issue at Par Value
Bonds issue at par value mean that the issuer sell bonds to investors at par value. The money receive equal to bonds par value.
The issuer needs to recognize the financial liability when publishing bonds into the capital market and cash is received. The company has the obligation to pay interest and principal at the specific date. Bonds will be issued at par value when the coupon rate equal to market rate, there is no discount or premium on bond.
Bonds Issue at Par Value Example
On 01 Jan 202X, Company A issue 6% bond at par value of $ 100,000. The bonds will be matured in 3 years. As the market rate is also 6%, so company can issue bonds at par value.
Journal Entry for Bonds Issue at Par Value
- The journal entry on Bond Issuance: On 01 Jan 202X, Company A needs to record debit cash and credit bonds payable. Cash is the amount that company receive from selling bond and it equal to company bonds payable.
| Account | Debit | Credit |
|---|---|---|
| Cash | 100,000 | |
| Bonds Payable | 100,000 |
You may wonder why don’t we discount cash flow bonds value which will be paid at the end of 3rd year. When the coupon rate equal to the effective interest rate, the present value of bond value and annual interest is equal to the par value.
- Journal Entry for interest expense: On 31 Dec 202X, the company needs to record debit interest expense and credit cash or interest payable. This journal entry need to record every year during bond term.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 6,000 | |
| Cash | 6,000 |
- Journal Entry on Bond Maturity date: On 31 Dec 202X+2, company A record debit bonds payable, interest expense and credit cash to investors. Company need to pay both interest expense (last year) and principal.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Interest Expense | 6,000 | |
| Cash | 106,000 |
Bonds Issue at Discount
Bonds Issue at discounted means that company sell bonds at a price which lower than par value. The company receive cash less than bond par value. Due to the market rate and coupon rate, company may issue the bonds with discount to the investor. Company will discount to attract investors when the coupon rate is lower than the market rate.
The discounted price is the total present value of total cash flow discounted at the market rate. The difference between cash receive and par value is recorded as discounted on bonds payable. This balance must be amortized over the term of bonds. The unamortized amount will be net off with bonds payable to present in the balance sheet.
Bonds Issue at Discount Example
On 01 Jan 202X, Company B issue 6%, bond with a par value of $ 100,000. The bond will be mature in 3 years and market rate is 8%. When the coupon rate is less than the effective interest rate, company must discount the bond to attract investors. How to calculate the bonds discounted price?
Bond price is the present value of future cash flow discount at market interest rate.
| Year | Cash flow | Discounted Factor | PV |
|---|---|---|---|
| 1 | 6,000 | 0.92592593 | 5,556 |
| 2 | 6,000 | 0.85733882 | 5,144 |
| 3 | 106,000 | 0.79383224 | 84,146 |
| Total | 94,846 |
When coupon rate is lower than market rate, company must calculate the market price of bonds. They will use the present value of future cash flow with market rate to calculate the bond selling price. In order to attract investors, company needs to sell bond at $ 94,846 only.
Journal Entry for Bonds issue at Discount
- Journal entry on bonds issue date: On 01 Jan 202X, company need to record cash receive, and discount on bonds payable and credit bonds payable.
| Account | Debit | Credit |
|---|---|---|
| Cash | 94,846 | |
| Discount on Bonds Payable | 5,154 | |
| Bonds Payable | 100,000 |
The discount on Bonds Payable will be net off with Bonds Payble to show in the balance sheet. So it means company B only record 94,846 ($ 100,000 – $ 5,151) on the balance sheet.
| Year | Bonds | Unamortized Discount | Carry Value | Interest Expense | Interest Paid |
|---|---|---|---|---|---|
| 0 | 100,000 | ||||
| 1 | 100,000 | 5,154 | 94,846 | 7,588 | 6,000 |
| 2 | 100,000 | 3,567 | 96,433 | 7,715 | 6,000 |
| 3 | 100,000 | 1,852 | 98,148 | 7,852 | 6,000 |
| Total | 100,000 | – | 100,000 |
By the end of third years, the discounted bonds payable balance will be zero, and bonds carry value will be $ 100,000.
- Journal entry at the end of first year: On 31 Dec 202X, Company records debit interest expense of $ 7,588 ($ 94,846 * 8%), credit cash paid $ 6,000 and Discount bonds payable $ 1,588. Company record interest expense base on the market rate but pay to investor base on coupon rate, so the different will credit bond discount which will be zero at the end of bond term.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 7,588 | |
| Discount on Bonds Payable | 1,588 | |
| Cash | 6,000 |
- Journal entry at the end of second year, 31 Dec 202X+1: company records interest expense $ 7,715 ($ 96,433 * 8%), credit cash paid $ 6,000 and discount on bonds payable $ 1,715.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 7,715 | |
| Discount on Bonds Payable | 1,715 | |
| Cash | 6,000 |
- Journal entry at the end of third year, 31 Dec 202X+2: company records interest expense $ 7,852 ($ 98,148 * 8%), credit cash paid $ 6,000 and discount on bonds payable $ 1,852.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 7,852 | |
| Discount on Bonds Payable | 1,852 | |
| Cash | 6,000 |
- Journal entry at the end of third year, to pay off bonds payable. Company debit bonds payable $ 100,000 and credit cash $ 100,000.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Cash | 100,000 |
Bonds issued at a Premium
Bonds issued at premium means the company sell bond at a price that is higher than par value. The company receives cash more than the bond par value. It happens as the bond coupon rate is higher than market rate, so investors will pay premium to enjoy higher return.
Company C issue 9%, 3 years bond when the market rate is only 8%, par value is $ 100,000. When the coupon rate is higher than effective interest rate, the company can sell bonds at a higher price. The company received cash of 105,154 which more than the bonds par value.
The price is arriving from the present value of all cash flow as following:
| Year | Cash flow | Discounted Factor | PV |
|---|---|---|---|
| 0 | |||
| 1 | 9,000 | 0.92592593 | 8,333 |
| 2 | 9,000 | 0.85733882 | 7,716 |
| 3 | 109,000 | 0.79383224 | 86,528 |
| Total | 102,577 |
Bond price is calculated by total the present value of interest and bond principal.
Journal Entry for Bonds Issue at Premium
- Journal entry on 01 Jan 202X: The company need to record cash receive $ 102,577 and credit Bonds Payable $ 100,000 while the different is Premium Bonds Payable $ 2,577.
| Account | Debit | Credit |
|---|---|---|
| Cash | 102,577 | |
| Premium on Bonds Payable | 2,577 | |
| Bonds Payable | 100,000 |
The balance of premium on bonds payable will be included in bonds payable. So on the balance sheet, carry value is $ 102,577 which is the present value of cash flow.
| Year | Bonds | Unamortized Premium | Carry Value | Interest Expense 8% | Interest Paid 9% |
|---|---|---|---|---|---|
| 0 | 100,000 | ||||
| 1 | 100,000 | 2,577 | 102,577 | 8,206 | 9,000 |
| 2 | 100,000 | 1,783 | 101,783 | 8,143 | 9,000 |
| 3 | 100,000 | 926 | 100,926 | 8,074 | 9,000 |
| Total | 100,000 | – | 100,000 |
- Journal entry at the end of first year, 31 Dec 202X: The company needs to record interest expense $ 8,206 ($ 102,577 * 8%), credit cash $9,000 ($ 100,000 * 9%) and the different is record as Premium on Bonds payable. Interest expense is based on the bond carry amount multiply by market interest rate. Cash paid to investors base on the par value and bond coupon rate.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 8,206 | |
| Premium on Bonds Payable | 794 | |
| Cash | 9,000 |
- Journal entry at the end of the second year, 31 Dec 202X+1: Similar to first year, we need to record interest expense ($ 101,783 * 8%), cash paid to investor and the different is the premium bonds payable.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 8,143 | |
| Premium on Bonds Payable | 857 | |
| Cash | 9,000 |
- Journal entry at the end of third year, 31 Dec 202X+2: Similar to prior year, we need to debit interest expense, premium bonds payable and credit cash paid to investors.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 8,074 | |
| Premium on Bonds Payable | 926 | |
| Cash | 9,000 |
At the end of the third year, premium bonds payable will be zero and the carrying amount of bonds payable will be $ 100,000. So the journal entry is debit bonds payable and credit cash paid to investors.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Cash | 100,000 |
Bonds Buyback Before Maturity
The company may decide to buyback bonds before the maturity date. Even bonds are issued at a premium or discounted, we need to calculate the carrying value and compare with the cash payment to calculate the gain or lose.
Company will pay a premium if they decide to buyback as the investor will lose some part of their interest income. It will happen when the market rate is declining, company can access the fund with a lower interest rate, so they can retire the bond early to save interest expense.
Bonds Buyback Before Maturity Example
As the company decides to buyback bonds before maturity, so the carrying amount is different from par value. It can be higher or lower than par value depend on each bond. We need to calculate the carrying amount and compare it with the purchase price to calculate gain or lose.
Continue from three examples above, assume all companies buyback the bonds at the end of second year. Here is the data which takes from three examples above. The purchase price is given below:
| Company | Bonds Payable | Premium or (Discount) | Carry Value | Purchase Price | Gain/(Loss) |
|---|---|---|---|---|---|
| Company A | 100,000 | – | 100,000 | 100,000 | – |
| Company B | 100,000 | (1,852) | 98,148 | 99,000 | (852) |
| Company C | 100,000 | 926 | 100,926 | 99,000 | 1,926 |
Journal Entry for Bonds Buyback
- Journal Entry for Company A: they buyback the bonds at carry value, so there is no gain or loss. We simply debit bonds payable and credit cash paid to investors.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Cash | 100,000 |
- Journal Entry for Company B: They buyback the bonds at higher price than carry value, the different is loss on bonds retirement. They needs to debit bonds payable $ 100,000, Loss $ 852 and credit cash $ 100,000 and discount bonds $ 1,852. As the bonds are buyback, we need to debit bonds balance, bonds discount, cash paid and the balancing figure is Loss on bonds retirements.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Loss on Bonds Retirement | 852 | |
| Cash | 99,000 | |
| Discounted on Bonds Payable | 1,852 |
- Journal Entry for Company C: They buyback bonds at lower price than carry value, the different is gain on bonds retirement. They need to debit bons payable $ 100,000, Premium $ 926 and credit Cash $ 99,000 & Gain $ 1,926. As the company buyback the bonds, they need to debit bonds payable, bonds premium, cash paid and the balancing figure is gain on bonds retirement.
| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Premium on Bonds Payable | 926 | |
| Cash | 99,000 | |
| Gain on Bonds retirement | 1,926 |