Chapter 16 – Bonds Payable.

Bonds

- Is an example of debt financing.

- The face (principle) amount of the bond will be repaid to the bondholders upon the
bond’s maturity date.
- A method of raising large sums of capital
- Is classified as a long term liability on the balance sheet
- Form of interest bearing note
- Any bond interest will be calculated using the bond coupon rate and will be paid out
semiannually
- Bondholders are deemed to be creditors of the company. They have a priority claim over
the stockholders. This is illustrated in the expression of the Accounting Equation as
follows: Assets – Liabilities = Stockholders Equity
- There is a legal obligation to pay the bond interest. If the company defaults on this
obligation the bondholders can sue them. Note: Under equity financing a corporation is
not legally obligated to issue dividends on stock. Dividends are a distribution of net
income to the stockholders and a company cannot guarantee that it will generate a profit.
- Corporations sell bonds to an investment firm called and underwriter. This underwriter
will sell the bonds to the public.

- Bonds are issued in denominations of $1000. Bonds are usually expressed as a

percentage of the face value at issuance.

(1) If Bond Is Issued at 100% - It is issued at par (face amount).

(2) If Bond Is Issued Above 100% - It is issued at a premium. Amortization of

the premium will occur over the life of the bond.

- As amortization occurs bond interest income is recorded

- As amortization occurs the bond carrying value decreases

- At maturity the carrying value of the bond equals the face amount

(3) If Bond Is Issued Below 100% - It is issued at a discount.

- Amortization of the discount will occur over the life of the bond

- As amortization occurs bond interest expense is recorded

- As amortization occurs the bond carrying value increases

- At maturity the carrying value of the bond will equal the face amount

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 Relationship Between the Bond Coupon Rate and The Prevailing Market Rate
(Effective Interest Rate)

(1) Bond coupon rate = Market Rate (Bond is issued at PAR)

(2) Bond coupon rate > Market Rate (Bond is issued at premium)

(3) Bond coupon rate < Market rate (Bond is issued at discount)

If the bond is issued between interest payment dates, the bondholder will pay the amount of the
bond and accrued interest.

Any accrued interest received by the issuing corporation will be recorded as a current liability.

This amount will be repaid to the bondholders along with the first payment (semi-annually) that
is made. The payment made is allocated between accrued interest payable and bond interest
expense.

Example 1:

Bond issued with a face amount of $100,000 for 10 years. Bond is issued at 88%. This bond is
issued at a discount because it is less than 100%.

Each bond issued 1,000 * 88% = 880

(1) Record entry for the issuance of the bond:

Cash (100,000 * 88%) 88,000

Discount on Bonds 12,000
Bonds Payable (Face Amount) 1000,000

Discount on Bonds

- A contra-liability account

Normal Balance is a debit.

To increase the account it is debited.
To decrease the account it is credited.

The total interest expense to be repaid over the life of the bonds is initially recorded in the
discount on bonds account. As the bonds remain outstanding, interest expense must be recorded
through the amortization of bond discount.

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 (2) Record Amortization

Interest Expense 1200

Discount on Bonds 1200

AT END OF YEAR 1

Straight Line Amortization of Discount

= Total Amount of Discount / Total Months in Bond Issue
= 12,000 / 120 months (10 yrs. * 12 months)
= 100 / month
Annual bond amortization 100 / month * 12 months = $1,200

Carrying Value (For bonds issued at discount)

At Issue End of Yr.1 At Maturity

Bonds Payable 100,000 100,000 100,000

Unamortized Discount 12,000 ↓ 10,800 0

Carrying Value 88,000 ↑ 89,200 100,000

- At issuance the carrying value will equal the proceeds received.

- At maturity, the carrying value will equal the face amount of the bond.

Record the Amortized Bond Discount

= Total Bond Discount / Number of Years

= 12,000 / 10
= 1,200 / year

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Record Annual Amortization (at a Discount)

Year 1

(A) Bond Interest Rate 1200

Discount on Bonds 1200

At Issue

Straight Line Method

Bond Amortization of Discount = Total Amount of Discount / Total Months in Bond Issue
= 12,000 / 120 months (10 yrs. * 12 months)
= 100 per month of amortized discount
Therefore annual bond amortization 100 / month * 12 months = $1,200

Journalize Bond Payment at Maturity

Bonds Payable 100,000

Cash 100,000

Repayment 100,000
Amount Initially Borrowed 88,000
Interest Expense 12,000

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Example 2:

A 10-year bond with a face amount of $100,000 is issued for 110,000.

A bond premium exists in the amount of 10,000.

Journal entry to record the issuance of the bond:

Cash 110,000
Premium on Bonds 10,000
Bonds Payable 100,000

At Issuance End Year 1 At Maturity

Bonds Payable 100,000 100,000 100,000

(Face Amount)

Add: Premium on Bonds 10,000 ↓ 9,000 0

Carrying Value 110,000 109,000 100,000

At issuance, the carrying value of the bond is equal to the proceeds being received.

At maturity, the carrying value of the bond is equal to the face amount.

Record Annual Amortization of Bond Premium

Total Premium / Total Years = 10,000 / 10 years

Year 1
Amortization of Bond Premium

Premium on Bonds 1,000

Bond Interest Income 1,000

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Record Repayment of Bond At Maturity

Bonds Payable 100,000

Cash 100,000

Amount Initially Borrowed 110,000

Amount 100,000

Interest Income 10,000

Example:

On January 1 a corporation issues for cash 100,000 for 12% five year bonds, with interest of
$6000 paid semiannually. However, the market rate is 11%. The bond will therefore sell at a
premium since the contract rate > market rate.

For present value purposes the market rate is always used in determining the present value of the
face amount at maturity and the semi annual interest payment.

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Present Value of a Bond

(1) The present value of face amount of 100,000 due in 5 years at 11% that is paid
semiannually (This would equal 5.5% interest for 10 periods).

100,000 * 0.5854 = 58,540

(PV of $1 for 10 periods at 5.5% interest)

(2) The present value of 10 semiannual interest (10 periods of 5.5%)payments 5

semiannually of $6000 at 11%.

6,000 * 7.5376 = 45,226

(PV of annuity of $1 for 10 periods at 5.5%)

Total present value (issue price) of bonds = 103,766