Bonds Payable

One source of financing available to corporations is long-term bonds. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semiannual basis. Unlike notes payable, which normally represent an amount owed to one lender, a large number of bonds are normally issued at the same time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior to their maturity.

Types of bonds
There are many different types of bonds available to interested investors. Some of the more common forms are:

Serial bonds. Bonds issued in groups that mature at different dates. For example, $5,000,000 of serial bonds, $500,000 of which mature each year from 514 years after they are issued.

Sinking fund bonds. Bonds that require the issuer to set aside a pool of assets used only to repay the bonds at maturity. These bonds reduce the risk that the company will not have enough cash to repay the bonds at maturity.

Convertible bonds. Bonds that can be exchanged for a fixed number of shares of the company's common stock. In most cases, it is the investor's decision to convert the bonds to stock, although certain types of convertible bonds allow the issuing company to determine if and when bonds are converted.

Registered bonds. Bonds issued in the name of a specific owner. This is how most bonds are issued today. Having a registered bond allows the owner to automatically receive the interest payments when they are made.

Bearer bonds. Bonds that require the bondholder, also called the bearer, to go to a bank or broker with the bond or coupons attached to the bond to receive the interest and principal payments. They are called bearer or coupon bonds because the person presenting the bond or coupon receives the interest and principal payments.

Secured bonds. Bonds are secured when specific company assets are pledged to serve as collateral for the bondholders. If the company fails to make payments according to the bond terms, the owners of secured bonds may require the assets to be sold to generate cash for the payments.

Debenture bonds. These unsecured bonds require the bondholders to rely on the good name and financial stability of the issuing company for repayment of principal and interest amounts. These bonds are usually riskier than secured bonds. A subordinated debenture bond means the bond is repaid after other unsecured debt, as noted in the bond agreement.

Bond prices
The price of a bond is based on the market's assessment of any risk associated with the company that issues (sells) the bonds. The higher the risk associated with the company, the higher the interest rate. Bonds issued with a coupon interest rate (also called contract rate or stated rate) higher than the market interest rate are said to be offered at apremium. The premium is necessary to compensate the bond purchaser for the above average risk being assumed. Bonds are issued at a discount when the coupon interest rate is below the market interest rate. Bonds sold at a discount result in a company receiving less cash than the face value of the bonds. Bonds are denominated in $1,000s. A market price of 100 means the bond sold for 100% of face value. If its face value is $1,000, the sales price was $1,000. A bond sold at 102, a premium, would generate $1,020 cash for the issuing company (102% $1,000) while one sold at 97, a discount, would provide $970 cash for the issuing company (97% $1,000). To illustrate how bond pricing works, assume Lighting Process, Inc. issued $10,000 of ten-year bonds with a coupon interest rate of 10% and semi-annual interest payments when the market interest rate is 10%. This means Lighting Process, Inc. will repay the principal amount of $10,000 at maturity in ten years and will pay $500 interest ($10,000 10% coupon interest rate 6/12) every six months. The price of the bonds is based on the present value of these future cash flows. The principal and interest amounts are based on the face amounts of the bond while the present value factors used to calculate the value of the bond at issuance are based on the market interest rate of 10%. Given these facts, the purchaser would be willing to pay $10,000, or the face value of the bond, as both the coupon interest rate and the market interest rate were the same. The total cash paid to investors over the life of the bonds is $20,000, $10,000 of principal at maturity and $10,000 ($500 20 periods) in interest throughout the life of the bonds. Present Value of Bond Sold at Market Interest Rate Cash Flows Present Value Factor Present Principal Payment $10,000 .3769 (1) $3,769

Interest Payments Price Bond

500

12.4622 (2)

6,231 $10,000

Assume instead that Lighting Process, Inc. issued bonds with a coupon rate of 9% when the market rate was 10%. The bond purchaser would be willing to pay only $9,377 because Lighting Process, Inc. will pay $450 in interest every six months ($10,000 9% 6/12), which is lower than the market rate of interest of $500 every six months. The total cash paid to investors over the life of the bonds is $19,000, $10,000 of principal at maturity and $9,000 ($450 20 periods) in interest throughout the life of the bonds. Present Value of Bond Sold Below Market Interest Rate Cash Flows Present Value Factor Present Value Principal Payment $10,000 Interest Payments Price of Bond 450 .3769 (1) 12.4622
(2)

$3,769 5,608 $9,377

If instead, Lighting Process, Inc. issued its $10,000 bonds with a coupon rate of 12% when the market rate was 10%, the purchasers would be willing to pay $11,246. Semi-annual interest payments of $600 are calculated using the coupon interest rate of 12% ($10,000 12% 6/12). The total cash paid to investors over the life of the bonds is $22,000, $10,000 of principal at maturity and $12,000 ($600 20 periods) in interest throughout the life of the bonds. Lighting Process, Inc. receives a premium (more cash than the principal amount) from the purchasers. The purchasers are willing to pay more for the bonds because the purchasers will receive interest payments of $600 when the market interest payment on the bonds was only $500. Present Value of Bond Sold Above Market Interest Rate Cash Flows Present Value Factor Present Value Principal Payment $10,000 Interest Payments Price of Bond 600 .3769 (1) 12.4622 (2) $3,769 7,477 $ 11,246

Bonds issued at par

The journal entries made by Lighting Process, Inc. to record its issuance at par of $10,000 tenyear bonds with a coupon rate of 10% and the semiannual interest payments made on June 30 and December 31 are as shown. General Journal Date 20X1 July 1 Cash 10,000 Account Title and Description Ref. Debit Credit

Bonds Payable Dec. 31 Interest Expense ($10,0000 10% ) Cash Semiannual interest payment * 20X2 June 30 Interest Expense ($10,000 10% 1/12) Cash Semiannual interest payment * 500 500

10,000

500

500

The bonds are classified as long-term liabilities when they are issued. When the bond matures, the principal repayment is recorded as follows: General Journal Date Account Title and Description Ref. Debit 10,000 10,000 Cash Paid off bonds at maturity Credit July 1 Bonds Payable

Bonds issued at a discount

Lighting Process, Inc. issues $10,000 ten-year bonds, with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, issued on July 1 when the market interest rate is 10%. The entry to record the issuance of the bonds increases (debits) cash for the $9,377 received, increases (debits) discount on bonds payable for $623, and increases (credits) bonds payable for the $10,000 maturity amount. Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long-term liability section of the balance sheet. Initially it is the difference between the cash received and the maturity value of the bond. General Journal Date 20X1 July 1 Cash Discount on Bonds Payable Bonds Payable Issue bonds at a discount After this entry, the bond would be included in the long-term liability section of the balance sheet as follows: Long-term liabilities Bonds Payable 10,000 9,377 623 10,000 Account Title and Description Ref. Debit Credit

Less: Discount on Bonds Payable (623)

9,377

The $9,377 is called the carrying amount of the bond. The discount on bonds payable is the difference between the cash received and the maturity value of the bonds and represents additional interest expense to Lighting Process, Inc. (the company that issued the bond). The total interest expense can be calculated using the bond-related payments and receipts as shown:

Repayments Principal Total cash payments to investors Less: Cash receipts from investors Total interest expense $10,000 19,000 (9,377) $ 9,623 Interest ($450 times 20 semiannual periods) 9,000

The interest expense is amortized over the twenty periods during which interest is paid. Amortization of the discount may be done using the straight-line or the effective interest method. Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different. If the amounts of interest expense are similar under the two methods, the straight-line method may be used. The straight-line method of allocating the discount to interest expense (also

called amortization of the discount) spreads the $623 of discount evenly over the 20 semiannual interest payments made for the bonds. To calculate the additional interest expense to be recognized when recording the semiannual interest payments, divide the total discount by the number of interest payments. In this example, an additional $31.15 ($623 20) of interest expense would be recognized every six months. This has been rounded to $31 for illustration purposes. The amount of discount amortized ($31) is added to the interest paid ($450) to determine the total interest expense recorded. The entry to pay interest on December 31, 20X1 would be: General Journal Date Account Title and Description Discount on Bonds Payable (623 20) Cash ($10,000 9% /12) Pay semiannual interest using straight-line amortization After the payment is recorded, the carrying value of the bonds payable on the balance sheet increases to $9,408 because the discount has decreased to $592 ($623$31).
6

Ref. Debit Credit 481 31 450

Dec. 31 Interest Expense

Long-term liabilities Bonds Payable 10,000 9,408 Less: Discount on Bonds Payable (592)

The carrying value will continue to increase as the discount balance decreases with amortization. When the bond matures, the discount will be zero and the bond's carrying value will be the same as its principal amount. The discount amortized for the last payment may be slightly different based on rounding. See Table 1 for interest expense calculated using the straight-line method of amortization and carrying value calculations over the life of the bond. At maturity, the entry to record the principal payment is shown in the General Journal entry that follows Table 1 . TABLE 1 Straight-Line Amortization of Discount Beginning Carrying Value (1) Interest Payment (2) 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 450 Discount Amoritzed (3) 31 31 31 31 31 31 31 31 31 31 31 31 31 31 31 31 31 31 31 * 34 Total Interest Beginning Expense Discount (5) (4)=(2)+(3) 481 481 481 481 481 481 481 481 481 481 481 481 481 481 481 481 481 481 481 484 9,623 Credit 10,000 623 592 561 530 499 468 437 406 375 344 313 282 251 220 189 158 127 96 65 34 Ending Discount (6)=(5)-(3) 592 561 530 499 468 437 406 375 344 313 282 251 220 189 158 127 96 65 34 0 Ending Carrying Value (7)=(1)+(3) 9,408 9,439 9,470 9,501 9,532 9,563 9,594 9,625 9,656 9,687 9,718 9,749 9,780 9,811 9,842 9,873 9,904 9,935 9,966 10,000

Date

7/1/X0 (A) 9,377 12/31/X0 9,377 6/30/X1 6/30/X2 6/30/X3 6/30/X4 6/30/X5 6/30/X6 6/30/X7 6/30/X8 6/30/X9 9,408 9,470 9,532 9,594 9,656 9,718 9,780 9,842 9,904 12/31/X1 9,439 12/31/X2 9,501 12/31/X3 9,563 12/31/X4 9,625 12/31/X5 9,687 12/31/X6 9,749 12/31/X7 9,811 12/31/X8 9,873 12/31/X9 9,935 6/30/X10 9,966

9,000 623 General Journal Date July 1 Bonds Payable Cash

Account Title and Description Ref. Debit 10,000

The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value 10% market interest rate 6/12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond 9% coupon interest rate 6/12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page. General Journal Date Account Title and Description
6

Ref. Debit Credit 469 19 450

Dec. 31 Interest Expense ($9,377 10% /12) Discount on Bonds Payable Cash ($ 10,000 9% /12) Pay semiannual interest using interest method of amortization
6

As the discount is amortized, the discount on bonds payable account's balance decreases and the carrying value of the bond increases. The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account. As with the straight-line method of amortization, at the maturity of the bonds, the discount account's balance will be zero and the bond's carrying value will be the same as its principal amount. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization TABLE 2 Interest Method of Amortization of Discount Beginning Carrying Value (1) Interest Expense (2) 469 470 471 472 473 474 475 477 478 479 Interest Payment (3) 450 450 450 450 450 450 450 450 450 450 Discount Amoritzed (4)=(2)-(3) 19 20 21 22 23 24 25 27 28 29 Beginning Discount (5) 623 601 584 563 541 518 494 469 442 414 Ending Discount (6)=(5)-(4) 604 584 563 541 518 494 469 442 414 385 Ending Carrying Value (7)=(1)+(4) 9,396 9,416 9,437 9,459 9,482 9,506 9,531 9,558 9,586 9,615

Date

7/1/X0 (A) 9,377 12/31/X0 9,377 6/30/X1 6/30/X2 6/30/X3 6/30/X4 6/30/X5 9,396 9,437 9,482 9,531 9,586 12/31/X1 9,416 12/31/X2 9,459 12/31/X3 9,506 12/31/X4 9,558

12/31/X5 9,615 6/30/X6 6/30/X7 6/30/X8 6/30/X9 9,646 9,712 9,785 9,865 12/31/X6 9,678 12/31/X7 9,748 12/31/X8 9,824 12/31/X9 9,908 6/30/X10 9,953

481 482 484 486 487 489 491 493 495 497 9,623

450 450 450 450 450 450 450 450 450 450 9,000

31 32 34 36 37 39 41 43 45 * 47 623

385 354 322 288 252 215 176 135 92 47

354 322 288 252 215 176 135 92 47 0

9,646 9,678 9,712 9,748 9,785 9,824 9,865 9,908 9,953 10,000

Bonds issued at a premium

On July 1, Lighting Process, Inc. issues $10,000 ten-year bonds, with a coupon rate of interest of 12% and semiannual interest payments payable on June 30 and December 31, when the market interest rate is 10%. The entry to record the issuance of the bonds increases (debits) cash for the $11,246 received, increases (credits) bonds payable for the $10,000 maturity amount, and increases (credits) premium on bonds payable for $1,246. Premium on bonds payable is a contra account to bonds payable that increases its value and is added to bonds payable in the long-term liability section of the balance sheet. General Journal Date 20X1 July 1 Cash Bonds Payable Premium on Bonds Payable Issue bonds at a premium After the entry, the bonds would be included in the long-term liability section of the balance sheet as follows: Long-term liabilities Bonds Payable 10,000 11,246 Plus: Premium on Bonds Payable 1,246 11,246 10,000 1,246 Account Title and Description Ref. Debit Credit

The premium account balance represents the difference (excess) between the cash received and the principal amount of the bonds. The premium account balance of $1,246 is amortized against interest expense over the twenty interest periods. Unlike the discount that results in additional

interest expense when it is amortized, the amortization of premium decreases interest expense. The total interest expense on these bonds will be $10,754 rather than the $12,000 that will be paid in cash. Repayments Principal Total cash payments to investors Less: Cash receipts from investors Total interest expense $10,000 22,000 (11,246) $10,754 Interest ($600 times 20 semiannual periods) 12,000

As with discount amortization, the amortization of premium may be done using the straight-line or effective interest method. The straight-line method spreads the $1,246 premium account's balance evenly over the 20 semiannual interest payments made for the bonds. This method divides the total premium by the number of interest payments to determine the reduction in interest expense to be recognized semiannually. In this case, interest expense will be reduced by $62.30 ($1,246 20), say $62, every six months. The entry for the first interest payment would be as follows: General Journal Date Account Title and Description Premium on Bonds Payable ($11,246 20) Cash ($10,000 12% /12) Pay semiannual interest (using straight-line amortization) The carrying value will continue to decrease as the premium account's balance decreases. When the bond matures, the premium account's balance will be zero and the bond's carrying value will be the same as the bond's principal amount. The premium amortized for the last payment should be the balance in the premium on bonds payable account. At maturity, the entry to record the principal repayment is: General Journal Date Account Title and Description Cash Repay bond principal at maturity See Table 3 for interest expense and carrying value calculations over the life of the bond using the straight-line method of amortization TABLE 3 Straight-Line Amortization of Premium Ref. Debit 10,000 10,000 Credit July 1 Bonds Payable
6

Ref. Debit Credit 538 62 600

Dec. 31 Interest Expense

Date

Beginning Carrying Value (1)

Interest Payment (2) 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 12,000

Premium Amoritzed (3) 62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 62 * 68 623

Total Interest Beginning Expense (4)=(2)-(3) Premium (5) 538 538 538 538 538 538 538 538 538 538 538 538 538 538 538 538 538 538 538 532 10,754 1,246 1,184 1,122 1,060 998 936 874 812 750 688 626 564 502 440 378 316 254 192 130 68

Ending Premium (6)=(5)-(3) 1,184 1,122 1,060 998 936 874 812 750 688 626 564 502 440 378 316 254 192 130 68 0

Ending Carrying Value (7)=(1)(3) 11,184 11,122 11,060 10,998 10,936 10,874 10,812 10,750 10,688 10,626 10,564 10,502 10,440 10,378 10,316 10,254 10,192 10,130 10,068 10,000

7/1/X0 (A) 11,246 12/31/X0 11,246 6/30/X1 6/30/X2 6/30/X3 6/30/X4 6/30/X5 6/30/X6 6/30/X7 6/30/X8 6/30/X9 11,184 11,060 10,936 10,812 10,688 10,564 10,440 10,316 10,192 12/31/X1 11,122 12/31/X2 10,998 12/31/X3 10,874 12/31/X4 10,750 12/31/X5 10,626 12/31/X6 10,502 12/31/X7 10,378 12/31/X8 10,254 12/31/X9 10,130 6/30/X10 10,068

. The effective interest method of amortizing the premium calculates interest expense using the carrying value of the bonds and the market interest rate when the bonds were issued. For the first payment, the interest expense is $562. It is calculated by multiplying the $11,246 (carrying value of the bonds) times 10% (market interest rate) 6/12 (semiannual payment). The amount of interest
6

paid

is

$600 ($10,000 face

value

of bonds

12%

coupon interest

rate

/12 semiannual payments). The $38 of premium amortization is the difference between the interest expense and the interest paid. The entry to record the first interest payment on December 31 using the effective interest method of amortizing the premium would be: General Journal Date Account Title and Description
6

Ref. Debit Credit 562 38

Dec. 31 Interest Expense ($11,246 10% /12) Premium on Bonds Payable

Cash ($10,000 12% 6/12) Pay semiannual interest using interest method of amortization

600

As the premium is amortized, the balance in the premium account and the carrying value of the bond decreases. The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account. As with the straight-line method of amortizing the premium, the effective interest method of amortizing the premium results in the premium account's balance being zero at the maturity of the bonds such that the carrying value of the bonds will be the same as the their principal amount. See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium. At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 . TABLE 4 Effective Interest Method of Amortizing the Premium Beginning Carrying Value (1) Interest Expense (2) 562 560 558 556 554 552 549 547 544 541 539 535 532 529 525 521 518 513 509 * 510 10,754 . Premium Amoritzed (3)=(4)-(2) 38 40 42 44 46 48 51 53 56 59 61 65 68 71 75 79 82 87 91
(A)

Date

Total Interest Payment (4) 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600 600

Beginning Premium (5) 1,246 1,208 1,168 1,126 1,082 1,036 988 937 884 828 769 708 643 575 504 429 350 268 181 90

Ending Premium (6)=(5)-(3) 1,208 1,168 1,126 1,082 1,036 988 937 884 828 769 708 643 575 504 429 350 268 181 90 0

Ending Carrying Value (7)=(1)(3) 11,208 11,168 11,126 11,082 11,036 10,988 10,937 10,884 10,828 10,769 10,708 10,643 10,575 10,504 10,429 10,350 10,268 10,181 10,090 10,000

7/1/X0 (A) 11,246 12/31/X0 11,246 6/30/X1 6/30/X2 6/30/X3 6/30/X4 6/30/X5 6/30/X6 6/30/X7 6/30/X8 6/30/X9 11,208 11,126 11,036 10,937 10,828 10,708 10,575 10,429 10,268 12/31/X1 11,168 12/31/X2 11,082 12/31/X3 10,988 12/31/X4 10,884 12/31/X5 10,769 12/31/X6 10,643 12/31/X7 10,504 12/31/X8 10,350 12/31/X9 10,181 6/30/X10 10,090

90

600 12,000

1,246

General Journal Date Account Title and Description Cash Repay bond principal at maturity Ref. Debit 10,000 10,000 Credit July 1 Bonds Payable

Bonds issued between interest dates

If a bond is sold at a time other than on its original issue date, the purchaser of the bond pays the issuing company the price of the bond plus accrued interest from the last interest payment date. This accrued interest is paid back to the purchaser who receives six months of interest at the next semiannual interest payment date. For example, if Lighting Process, Inc. issued $10,000 ten-year 10% bonds dated July 1, 20X0, on September 1, 20X0, the purchaser would pay the $10,000 for the bonds and interest of $167 ($10,000 10%2/12) for two months. On December 31, the purchaser would receive a semiannual interest payment of $500 ($10,000 10%6/12) as if the purchaser had owned the bonds for the entire six-month period. The entries for these two events would be: General Journal Date 20X0 Sept. 1 Cash Bonds Payable Bond Interest Payable ($10,000 10% /12) Issue $10,000 10% bonds dated 7/1 Dec. 31 Bond Interest Payable Bond Interest Expense ($ 10,000 10% /12) Cash Pay semiannual interest
4 2

Account Title and Description

Ref. Debit 10,167

Credit

10,000 167

167 333 500