Professional Documents
Culture Documents
Recording Entries For Bonds
Recording Entries For Bonds
When a company issues bonds, it incurs a long-term liability on which periodic interest
payments must be made, usually twice a year. If interest dates fall on other than
balance sheet dates, the company must accrue interest in the proper periods. The
following examples illustrate the accounting for bonds issued at face value on an
interest date and issued at face value between interest dates.
De
Bonds Payable
On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020
June 30), the entry would be (Remember, calculate interest as Principal x Interest x
Frequency of the Year):
Cash
On December 31 (10 years later), the maturity date, the entry would include the last
interest payment and the amount of the bond:
Dec 31 Bond Interest Expense ($100,000 x 12% x 6 months / 12 months)
Bonds Payable
Cash
Note that Valley does not need any interest adjusting entries because the interest
payment date falls on the last day of the accounting period. The income statement for
each of the 10 years would show Bond Interest Expense of $12,000 ($ 6,000 x 2
payments per year); the balance sheet at the end of each of the years 1 to 8 would
report bonds payable of $100,000 in long-term liabilities. At the end of ninth year, Valley
would reclassify the bonds as a current liability because they will be paid within the next
year.
The real world is more complicated. For example, assume the Valley bonds were
dated October 31, issued on that same date, and pay interest each April 30 and
October 31. Valley must make an adjusting entry on December 31 to accrue interest
earned for November and December but not paid until April 30 of the next year. That
entry would be:
The April 30 entry in the next year would include the accrued amount from December of
last year and interest expense for Jan to April of this year. We will credit cash since we
are paying cash to the bondholders.
Cash
Each year Valley would make similar entries for the semiannual payments and the year-
end accrued interest. The firm would report the $2,000 Bond Interest Payable as a
current liability on the December 31 balance sheet for each year.
It would be nice if bonds were always issued at the par or face value of the bonds. But,
certain circumstances prevent the bond from being issued at the face amount. We may
be forced to issue the bond at a discount or premium. This video will explain the basic
concepts and then we will review examples:
The price of a bond issue often differs from its face value. The amount a bond sells for
above face value is a premium. The amount a bond sells for below face value is
a discount. A difference between face value and issue price exists whenever the
market rate of interest for similar bonds differs from the contract rate of interest on the
bonds. The effective interest rate (also called the yield) is the minimum rate of interest
that investors accept on bonds of a particular risk category. The higher the risk
category, the higher the minimum rate of interest that investors accept. The contract
rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay
interest. Firms state this rate in the bond indenture, print it on the face of each bond,
and use it to determine the amount of cash paid each interest period. The market rate
fluctuates from day to day, responding to factors such as the interest rate the Federal
Reserve Board charges banks to borrow from it; government actions to finance the
national debt; and the supply of, and demand for, money.
Market and contract rates of interest are likely to differ. Issuers must set the contract
rate before the bonds are actually sold to allow time for such activities as printing the
bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the
market rate is equal to the contract rate, the bonds will sell at their face value. However,
by the time the bonds are sold, the market rate could be higher or lower than the
contract rate.
Market Rate = Contract Rate Bond sells at par (or face or 100%)
Market Rate < Contract Rate Bonds sells at premium (price greater than 100%)
Market Rate > Contract Rate Bond sells at discount (price less than 100%)
As shown above, if the market rate is lower than the contract rate, the bonds will sell for
more than their face value. Thus, if the market rate is 10% and the contract rate is 12%,
the bonds will sell at a premium as the result of investors bidding up their price.
However, if the market rate is higher than the contract rate, the bonds will sell for less
than their face value. Thus, if the market rate is 14% and the contract rate is 12%, the
bonds will sell at a discount. Investors are not interested in bonds bearing a contract
rate less than the market rate unless the price is reduced. Selling bonds at a premium
or a discount allows the purchasers of the bonds to earn the market rate of interest on
their investment.
Issuers usually quote bond prices as percentages of face value—100 means 100% of
face value, 97 means a discounted price of 97%of face value, and 103 means a
premium price of 103% of face value. For example, one hundred $1,000 face value
bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%).
Regardless of the issue price, at maturity the issuer of the bonds must pay the
investor(s) the face value (or principal amount) of the bonds.
For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of
95 1/2 or 95.50% with interest to be paid semi-annually on June 30 and December 30
for cash. We know this is a discount because the price is less than 100%. The entry to
record the issue of the bond on January 1 would be:
In the balance sheet, the bonds would be reported with a carrying value equal to the
cash received of $95,500 reported as:
Long-term Liabilities:
When a company issues bonds at a premium or discount, the amount of bond interest
expense recorded each period differs from bond interest payments. The bond pays
interest every 6 months on June 30 and December 31. We will amortize the discount
using the straight-line method meaning we will take the total amount of the discount
and divide by the total number of interest payments. In this example the discount
amortization will be $4,500 discount amount / 6 interest payment (3 years x 2 interest
payments each year). The entry to record the semi-annual interest payment and
discount amortization would be:
Deb
Cash
Bonds Payable ($100,000 bond amount)
For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of
105 1/4 or 105.25% with interest to be paid semi-annually on June 30 and December 30
for cash. We know this is a discount because the price is less than 100%. The entry to
record the issue of the bond on January 1 would be:
Long-term Liabilities:
Jun 30 Bond Interest Expense ($6,000 cash interest – 875 premium amortization)
Just like with a discount, we would have completely amortized or removed the premium
so the balance in the premium account would be zero. Our entry at maturity would be:
Deb
Cash
Bonds issued at face value between interest dates Companies do not always issue
bonds on the date they start to bear interest. Regardless of when the bonds are
physically issued, interest starts to accrue from the most recent interest date. Firms
report bonds to be selling at a stated price “plus accrued interest”. The issuer must pay
holders of the bonds a full six months’ interest at each interest date. Thus, investors
purchasing bonds after the bonds begin to accrue interest must pay the seller for the
unearned interest accrued since the preceding interest date. The bondholders are
reimbursed for this accrued interest when they receive their first six months’ interest
check.
Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued
its bonds on May 31, instead of on December 31. The entry required is:
May 31 Cash
Bonds payable
This entry records the $5,000 received for the accrued interest as a debit to Cash and a
credit to Bond Interest Payable.
The entry required on June 30, when the full six months’ interest is paid, is:
Cash
This entry records $1,000 interest expense on the $100,000 of bonds that were
outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as
accrued interest and is now returning it to them.