Accounting: The Language of Business (Part 92)

As an artist, your only way to battle your label if you have a discrepancy is to go to court. I don't understand why you can't both agree if you have an accounting problem to have a third party to assess the situation.

Martie Maguire

Bonds Payable and Investments in Bonds (Part C)

by

Charles Lamson

Bond Sinking Funds

A bond indenture may restrict dividend payments to stockholders as a means of increasing the likelihood that the bonds will be paid at maturity. In addition to or instead of this restriction, the bond indenture may require that funds for the payment of the face value of the bonds at maturity be set aside over the life of the bond issue. The amounts set aside are kept separate from other assets in a special fund called a sinking fund.

When cash is transferred to the sinking fund, it is recorded in an account called Sinking Fund Cash. When investments are purchased with the sinking fund cash, they are recorded in an account called Sinking Fund Investments. As income (interest or dividends) is received, it is recorded in an account called Sinking Fund Revenue.

Sinking fund revenue represents earnings of the corporation and is reported in the income statement as Other Income. The cash and the securities making up the sinking fund are reported in the balance sheet as Investments, immediately below the Current Assets section.

Bond Redemption

A corporation may call or redeem bonds before they mature. This is often done if the market rate of interest declines significantly after the bonds have been issued. In this situation, the corporation may sell new bonds at a lower interest rate and use the funds to redeem the original bond issue. The corporation can thus save on future interest expenses.

A corporation often issues callable bonds to protect itself against significant declines in future interest rates. However, callable bonds are more risky for investors, who may not be able to replace the called bonds with investments paying an equal amount of interest.

Callable bonds can be redeemed by the issuing corporation within the period of time and at the price stated in the bond indenture (contract associated with a bond). Normally, the call price is above the face value. A corporation may also redeem its bonds by purchasing them on the open market.

A corporation usually redeems its bonds at a price different from that of the carrying amount (or book value) of the bonds. The carrying amount of bonds payable is the balance of the bonds payable account (face amount of the bonds) less any unamortized discount or plus any unamortized premium. If the price paid for redemption is below the bond carrying amount, the difference in these two amounts is recorded as a gain. If the price paid for the redemption is above the carrying amount, a loss is recorded. Gains and losses on the redemption of bonds are reported to the Other Income and Expense section of the income statement.

To illustrate, assume that on June 30 a corporation has a bond issue of $100,000 outstanding, on which there is an unamortized premium of $4,000. Assuming that the corporation purchases 1/4 ($25,000) of the bonds for $24,000 on June 30 the entry to record the redemption is as follows:

In the preceding entry, only a portion of the premium relating to the redeemed bonds is written off. The difference between the carrying amount of the bonds purchased, $26,000 ($25,000 + $1,000), and the price paid for the redemption, $24,000 is recorded as a gain.

If the corporation calls the entire bond issue for $105,000 on June 30, the entry to record the redemption is as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 612-613*

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