Accounting: The Language of Business (Part 91)

One of the things that we're missing from our political dialogue right now is the idea that the United States is a home. It is more than an accounting sheet. It is more than the sum of its G.D.P., its total tax collections, or its total outlays. America is a family.

Stephen Miller

Bonds Payable and Investments in Bonds (Part B)

by

Charles Lamson

Accounting for Bonds Payable

In (part 90), we described and Illustrated how present value concepts are used in determining how much buyers are willing to pay for bonds. In this post, we describe and illustrate how corporations record the issuance of bonds and the payment of bond interest.

Bonds Issued at Face Amount

To illustrate the journal entries for issuing bonds, assume that on January 1, 2022, a corporation issues for cash $100,000 of 12%, five-year bonds, with interest of $6,000 payable semiannually. The market rate of interest at the time the bonds are issued is 12%. Since the contract rate and the market rate of interest are the same, the bonds will sell at their face amount. This amount is the sum of (1) the present value of the face amount of $100,000 to be repaid in five years and (2) the present value of 10 semiannual interest payments of $6,000 each. This computation and a timeline are shown below.

The following entry records the issuing of the $100,000 bonds at their face amount:

Every six months after the bonds have been issued, interest payments of $6,000 are made. The first interest payment is recorded as shown below.

At the maturity date, the payment of the principle of $100,000 is recorded in the journal as follows:

Bonds Issued at a Discount

What if the market rate of interest is higher than the contract rate of interest? If the market rate of interest is 13% and the contract rate is 12% on the five-year, $100,000 bonds, the bonds will sell at a discount. The present value of these bonds is calculated as follows:

The two present values that make up the total are both less than the related amounts in the preceding example. This is because the market rate of interest was 12% in the first example, while the market rate of interest is 13% in this example. The present value of a future amount becomes less and less as the interest rate used to compute the present value increases.

The journal entry to record the issuing of the $100,000 bonds at a discount is shown below.

The $3,594 discount may be viewed as the amount that is needed to entice investors to accept a contract rate of interest that is below the market rate. You may think of the discount as the market's way of adjusting a bond's contract rate of interest to the higher market rate of interest. Using this logic, generally accepted accounting principles require that bond discounts be amortized (In business, amortization refers to spreading payments over multiple periods.) as interest expense over the life of the bond.

Amortizing a Bond Discount

There are two methods of amortizing a bond discount: (1) the straight-line method and (2) the effective interest rate method, often called the interest method. Both methods amortize the same total amount of discount over the life of the bonds. The interest method is required by generally accepted accounting principles. However the straight-line method is acceptable if the results obtained do not materially differ from the results that would be obtained by using the interest method. Because the straight-line method illustrates the basic concept of amortizing discounts and is simpler, we will use it in the next few posts. The interest method will be illustrated in an upcoming post.

The straight-line method of amortizing a bond discount provides for amortization in equal periodic amounts. Applying this method to the preceding example yields amortization of 1/10 of $3,594, or $359.40, each half year. The amount of the interest expense on the bonds is the same, $6,359.40 ($6,000 + $359.40) for each half year. The entry to record the first interest payment and the amortization of the related discount follows.

Bonds Issued at a Premium

If the market rate of interest is 11% and the contract rate is 12% on the five-year, $100,000 bonds, the bonds will sell at a premium. The present value of these bonds is computed as follows:

The entry to record the issuing of the bonds is as follows:

Amortizing a Bond Premium

The amortization of bond premiums is basically the same as that for bond discounts, except that interest expense is decreased. In the above example, the straight-line method yields amortization of 1/10 of $3,769, or $376.90, each half year the entry to record the first interest payment and the amortization of the related premium is as follows:

Zero-Coupon Bonds

Some corporations issue bonds that provide for only the payment of the face amount at the maturity date. Such bonds are called zero-coupon bonds. Because they do not provide for interest payments, these bonds sell at a large discount.

The issuing price of zero-coupon bonds is the present value of their face amount. To illustrate, if the market rate of interest is 13%, the present value of $100,000 zero-coupon, five-year bonds is calculated as follows:

The accounting for zero-coupon bonds is similar to that for interest-bearing bonds that have been sold at a discount. The discount is amortized as interest expense over the life of the bonds. The entry to record the issuing of the bond is as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 608-612*

end

0