Bond accounting principles
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. Let’s 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 bond’s 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. We’ll now turn our attention to accounting entries for the periodic interest payments.
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