Bond accounting principles

March 2, 2014

In theory, bonds are easy to account for. A long-term liability is established on the balance sheet, and periodic interest expense is applied to the calculation of net income. When the bond is repaid, the liability is cleared from the balance sheet. Not all bonds, however, are that simple to handle.

1. Initial bond valuation and journal entries

Bonds that are issued at face value follow the simple methodology described in the introduction. If, however, the stated interest rate (or coupon rate) of the bond is lower than the market rate demanded by investors, they will not pay face value for the bond. On the other hand, if the interest rate is higher than the market rate, the same investors will pay a premium for the security. Letís look at an example of a corporation that issues a 10-year, $1,000,000 bond with an interest rate of 6% and payments made annually. If the market rate is 7% for similar bonds, the corporation will receive less than $1,000,000 for the bond. How do we determine the bondís price? We must discount all future cash flows, calculated with the coupon rate, using the market rate (effective yield) demanded by investors. The chart below illustrates the math involved, and it also shows what would happen to the bond price if the market rate is 5% instead of 7%.

 

Bond Repayment

Ten Interest Payments, 6%

Total

7% Market Rate

     

Undiscounted Amount

$1,000,000

Annual annuity of $60,000

$1,600,000

Time Value Factor

0.508 (PV, 7%, 10 periods)

7.024 (PVA, 7%, 10 periods)

 

Discounted Amount

$508,000

$421,440

$929,440

       

5% Market Rate

     

Undiscounted Amount

$1,000,000

Annual annuity of $60,000

$1,600,000

Time Value Factor

0.614 (PV, 5%, 10 periods)

7.772 (PVA, 5%, 10 periods)

 

Discounted Amount

$614,000

$466,320

$1,080,320

The following journal entries will be made at issuance for a bond issued at face value, at a discount, and at a premium, respectively.

Account Names

Debits

Credits

Cash

1,000,000

 

†††† Bonds Payable

 

1,000,000

     

Cash

929,440

 

Discount on Bonds Payable

70,560

 

†††† Bonds Payable

 

1,000,000

     

Cash

1,080,320

 

†††† Premium on Bonds Payable

 

80,320

†††† Bonds Payable

 

1,000,000

We use contra accounts called Discount on Bonds Payable and Premium on Bonds Payable to balance the difference between cash received and the face value of the eventual repayment. Weíll now turn our attention to accounting entries for the periodic interest payments.

Not a member?
See why people join our
online accounting course:
Lecture Contents:
Free Study Notes
Download free accounting study notes by signing up for our free newsletter (example):
First Name:
E-mail:
We never share or sell your e-mail to third parties.