Recording Entries for Bonds Financial Accounting

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. 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 difference in the stated rate and the market rate determine the accounting treatment of the transactions involving bonds. 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.

What is the Discount on Bonds Payable?

A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold. The interest expense is calculated by taking the Carrying Value ($91,800) multiplied by the market interest rate (7%).

Under the effective-interest method, the interest expense is calculated by taking the Carrying (or Book) Value ($104,460) multiplied by the market interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate. Municipal bonds, like other bonds, pay periodic interest based on the stated interest rate and the face value at the end of the bond term.

Free Financial Statements Cheat Sheet

Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022. The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. Because the bonds have a 5-year life, there are 10 interest payments (or periods). The periodic interest is an annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the tenth period.

The premium or discount is to be amortized to interest expense over the life of the bonds. Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of accounting standards. With two exceptions, bonds payable are primarily the same under the two sets of standards. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. If the market rate is equal to the contract rate, the bonds will sell at their face value.

This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. This entry records the $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. The April 30 entry in the next year would include the accrued amount from December of last year and interest expense for Jan to April of this year. Over the life of the bonds, the initial debit balance in Discount on Bonds Payable will decrease as it is amortized to Bond Interest Expense. When a bond is issued at a premium, the carrying value is higher than the face value of the bond. When a bond is issued at a discount, the carrying value is less than the face value of the bond.

Module 12: Non-Current Liabilities

The actual interest paid out (also known as the coupon) will be higher than the expense. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date.

• Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest.
• 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.
• For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530).
• Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.
• Recall from the discussion in Explain the Pricing of Long-Term Liabilities that one way businesses can generate long-term financing is by borrowing from lenders.

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 . When we issue a bond at a premium, we are selling the bond for more than it is worth.

Straight-Line Amortization of Bond Discount on Annual Financial Statements

Schultz will have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). The premium or the discount on bonds payable that has not yet been amortized to interest expense will be reported immediately after the par value of the bonds in the liabilities section of the balance sheet. Generally, if the bonds are not maturing within one year of the balance sheet date, the amounts will be reported in the long-term or noncurrent liabilities section of the balance sheet. Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination of the specific characteristics of a bond issue and the actual issuance of the bond.

• Over the life of the bonds, the initial debit balance in Discount on Bonds Payable will decrease as it is amortized to Bond Interest Expense.
• At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 .
• The carrying value of a bond is not equal to the bond payable amount unless the bond was issued at par.

The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable. A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept.

Accounting Principles II

At the end of 5 years, the company will retire the bonds by paying the amount owed. Remember that the bond payable retirement debit entry will always be the face amount of the bonds since, when the bond matures, any discount or premium will have been completely amortized. Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face value.

The debit balance in the Discount on Bonds Payable account will gradually decrease as it is amortized to Interest Expense over their life. The present value factors are taken from the present value tables (annuity and lump-sum, respectively). Take time to verify the factors by reference to the appropriate tables, spreadsheet, or calculator https://online-accounting.net/ routine. The present value factors are multiplied by the payment amounts, and the sum of the present value of the components would equal the price of the bond under each of the three scenarios. See Table 3 for interest expense and carrying value calculations over the life of the bond using the straight‐line method of amortization .

However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. The income statement for all of 20X3 would include $6,294 of interest expense ($3,147 X 2). This method of accounting for bonds is known as the straight-line amortization method, as interest expense is recognized uniformly over the life of the bond. Notice that interest expense is the same each year, even though the net book value of the bond (bond plus remaining premium) is declining each year due to amortization.

Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check. The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%). Since the market rate and the stated rate are different, we again need to account for the difference between the amount of interest expense and the cash paid to bondholders. When a company issues bonds, they make a promise to pay interest annually or sometimes more often. If the interest is paid annually, the journal entry is made on the last day of the bond’s year.

By the end of the 5th year, the bond premium will be zero and the company will only owe the Bonds Payable amount of $100,000. By the end of the 5th year, the bond premium will be zero, and the company will only owe the Bonds Payable amount of $100,000. As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) that was implicit in the pricing of the bonds. For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4, interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412). Emilie is a Certified Accountant and Banker with Master’s in Business and 15 years of experience in finance and accounting from corporates, financial services firms – and fast growing start-ups.

Since they promised to pay 5% while similar bonds earn 7%, the company, accepted less cash up front. They did this because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value but paying 7% interest. Computing long-term here’s how capital gains taxes on investment properties work bond prices involves finding present values using compound interest. Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The price investors pay for a given bond issue is equal to the present value of the bonds.