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 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 and 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 the fund. It is the company who borrow the money and promise to pay interest and principal.
  • Holder or investors: is the person or company who buys the bonds in exchange for annual interest receive 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 multiple its number. However, the lender can receive the principal before the maturity date by selling bonds to the capital market. The borrower will pay back the principal to whoever holds the bonds on maturity date.

Bond Carrying Amount

Bonds Payable usually equal to Bonds carry amount unless at 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). By the maturity date, bonds carry amount must be equal to bonds par value.

Accounting for Bonds

Bond Issuance at 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 Issuance 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.

  • The journal entry on 01 Jan 202X:
Account Debit Credit
Cash 100,000
Financial lability-Bonds 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.

  • 31 Dec 202X, the company needs to record interest expense and interest paid.
Account Debit Credit
Interest Expense 6,000
Cash 6,000

The accounting record will be the same for interest expense in each year.

  • 31 Dec 202X+2: On the bonds maturity date, company A need to pay both interest expense and principal:
Account Debit Credit
Financial Liability-Bonds 100,000
Interest Expense 6,000
Cash 106,000

Bonds Issue at a Discounted

Due to the market rate and coupon rate, company may issue the bonds and provide a discount to the investor. It means that company sells bonds at a price that is lower than the par value. 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 the 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 a Discounted 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 B must discount the bond. How to calculate the bonds discounted price?

Discounted bond price is the presented value of all cash flow from bond.

Year Cash flow Discounted Factor PV at
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.

  • Journal entries for 01 Jan 202X:
Account Debit Credit
Cash 94,846
Discount on Bonds Payable 5,154
Financial lability-Bonds 100,000

The discount on Bonds Payable will be net off with Financial Liability – Bonds 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 InterestExpense InterestPaid
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 at the end of first year, 31 Dec 202X
Account Debit Credit
Interest Expense 7,588
Discount on Bonds Payable 1,588
Cash 6,000
  • Journal at the end of second year, 31 Dec 202X+1
Account Debit Credit
Interest Expense 7,715
Discount on Bonds Payable 1,715
Cash 6,000
  • Journal at the end of third year, 31 Dec 202X+2
Account Debit Credit
Interest Expense 7,852
Discount on Bonds Payable 1,852
Cash 6,000
  • To record the payment of the bond
Account Debit Credit
Financial Liability – Bonds 100,000
Cash 100,000

Bonds issued at a Premium

Company C issue 9%, 3 years bond when the market rate is only 8%. 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 at
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
  • Journal entries for 01 Jan 202X:
Account Debit Credit
Cash 102,577
Premium on Bonds Payable 2,577
Financial lability-Bonds 100,000

The balance of premium on bonds payable will be included in financial liability-bonds. So on the balance sheet, carry value is $ 102,577 which is the present value of cash flow.

Year Bonds Unamortized Premium Carry Value InterestExpense InterestPaid
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 for the end of first year, 31 Dec 202X
Account Debit Credit
Interest Expense 8,206
Premium on Bonds Payable 794
Cash 9,000
  • Journal entry for the end of the second year, 31 Dec 202X+1
Account Debit Credit
Interest Expense 8,143
Premium on Bonds Payable 857
Cash 9,000
  • Journal entry for the end of third year, 31 Dec 202X+2
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.

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 deciding 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 much lower rate, so they can retire the bond dearly to save on interest expense.

Bonds Buyback Before Maturity Example

Continue from three examples above, assume company buyback the bonds at $ 100,000 at the end of second year.

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.

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)          98,148 100,000           (1,852)
Company C            100,000              926        100,926 100,000            926
  • Bonds Buyback Journal Entry for Company A
Account Debit Credit
Bonds Payable 100,000
Cash 100,000
  • Bonds Buyback Journal Entry for Company B
Account Debit Credit
Bonds Payable 100,000
Loss 1,852
Cash 100,000
Discounted Bonds 1,852
  • Bonds Buyback Journal Entry for Company C
Account Debit Credit
Bonds Payable 100,000
Premium 926
Cash 100,000
Gain 926