In accounting for liabilities, a controller must consider many reporting and disclosure responsibilities. Two of those many reporting concern are: “Bonds payable may be issued between interest dates at a premium or discount” and “Bonds may be amortized using the straight-line method or effective interest method”. How are bonds payable accounted? What journal entry made for bond payable? This post emphasize to this two main concerns specifically.

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The cost of a corporate bond is expressed in terms of “yield“. Two types of yield are:

[1]. Simple Yield, the equation is: 

Simple Yield = Nominal interest/Present value of bond

It is not as accurate as yield to maturity.

 

[2]. Yield to Maturity (Effective Interest Rate). The equation is somewhat complex, but do not worry, we will get this done through some easy case examples 🙂  for the moment here is the equation:

[[Nominal interest + [Discount/Years] ? [Premium]/Years]/[Present value of bond + Maturity value]/2

 

EXAMPLE: A $100,000, 10 percent five-year bond is issued at $96.

The simple yield is:

Nominal interest/Present value of bond = $10,000/$96,000 = 10.42%

Important: When a bond is issued at a discount, the yield (effective interest rate) exceeds the nominal (face, coupon) interest rate. When a bond is issued at a premium, the yield is below the nominal interest rate.

 

The two methods of amortizing bond discount or bond premium are:

  1. Straight-line method – It results in a constant dollar amount of amortization but a different effective rate each period.
  2. Effective interest method – It results in a constant rate of interest but different dollar amounts each period. This method is preferred over the straight-line method.

 

The amortization journal entry is:

[Debit]. Interest expense = [Yield × Carrying value of bond at the beginning of the year]
[Credit]. Discount
[Credit]. Cash = [Nominal interest × Face value of bond]

Note: In the early years, the amortization amount under the effective interest method is lower relative to the straight-line method (either for discount or premium).

 

EXAMPLE: On 1/1/20X8, a $100,000 bond is issued at $95,624. The yield rate is 7 percent, and the nominal interest rate is 6 percent. The following schedule is the basis for the journal entries:

 

Date                  Debit            Credit           Credit           Carrying
                         Interest         Cash            Discount       Value
                         Expense
1/1/20X8                                                                       $95,624
12/31/20X8     $6,694          $6,000         $694               96,318
12/31/20X9       6,742            6,000           742               97,060

 

The entry on 12/31/20X8 is:

[Debit]. Interest expense = $6694
[Credit]. Cash = $6000
[Credit]. Discount = $694

At maturity, the bond will be worth its face value of $100,000. When bonds are issued between interest dates, the journal entry is:

[Debit]. Cash
[Credit]. Bonds payable
[Credit]. Premium (or debit discount)
[Credit]. Interest expense

 

EXAMPLE: A $100,000, 5 percent bond having a life of five years is issued at 110 on 4/1/20X8. The bonds are dated 1/1/20X8. Interest is payable on 1/1 and 7/1. Straight line amortization is used.

The journal entries are:

On the 4/1/20X8:

[Debit]. Cash (110,000 + 1,250) = $111,250
[Credit]. Bonds payable = $100,000
[Credit]. Premium on bonds payable = $10,000
[Credit]. Bond interest expense = $1,250
(Note: 100,000 × 5% × 3/12 = 1,250)

 

On the 7/1/20X8:  

[Debit]. Bond interest expense = $2,500
[Credit]. Cash = $2,500
(Note: 100,000 × 5% × 6/12 = 2,500)

and;

[Debit]. Premium on bonds payable = $526.50
[Credit]. Bond interest expense = $526.50

Note: The $526 came from the following calculation:
4/1/20X8—1/1/2012 = 4 years, 9 months = 57 months
$10, 000/ 57 = $175.50 per month
$175.50 × 3 months = $526.50

 

On the 12/31/20X8:

[Debit]. Bond interest expense = $2,500
[Credit]. Interest payable = $2,500

and;

[Debit]. Premium on bonds payable = $1,053
[Credit]. Bond interest expense = $1,053

 

On the 1/1/20X9:

[Debit]. Interest payable = $2,500
[Credit]. Cash = $2,500

 

Bonds payable is presented on the balance sheet at its present value in this manner:

Bonds payable
Add: Premium
Less: Discount
Equal: Carrying value

Bond issue costs are the expenditures in issuing the bonds such as legal, registration, and printing fees. Bond issue costs are preferably deferred and amortized over the life of the bond. They are shown under Deferred Charges.

In computing the price of a bond, the face amount is discounted using the “present value of $1 table“. The interest payments are discounted using the “present value of an ordinary annuity of $1 table“. The yield serves as the “discount rate“.

EXAMPLE: A $50,000, 10-year bond is issued with interest payable semiannually at an 8 percent nominal interest rate. The yield rate is 10 percent. The present value of $1 table factor for n = 20, i = 5% is 0.37689. The present value of annuity of $1 table factor for n = 20, i = 5% is 12.46221. The price of the bond equals:

Present value of principal = $50,000 × 0.37689 = $18,844.50
[Add] Present value of interest payments = $20,000 × 12.46221 = 24,924.42
[Equal] Price of the bond = $43,768.92

Let’s expand a little bit with the following question…..

 

What If Bonds Are Converted to Stock?

In converting a bond into stock, three alternative methods may be used: (1) book value of bond, (2) market value of bond, and (3) market value of stock. Under the book value of bond method, no gain or loss on bond conversion arises because the book value of the bond is the basis to credit equity. This method is preferred. Under the market value methods, gain or loss will result because the book value of the bond will be different from the market value of bond or market value of stock, which is the basis to credit the equity accounts.

EXAMPLE: A $100,000 bond with unamortized premium of $8,420.50 is converted to common stock. There are 100 bonds ($100,000/$1,000). Each bond is converted into 50 shares of stock. Thus, there are 5,000 shares of common stock. Par value is $15 per share. The market value of the stock is $25 per share. The market value of the bond is 120.

Using the book value method, journal entry for the conversion is:

[Debit]. Bonds payable = $100,000
[Debit]. Premium on bonds payable = $8,420.50
[Credit]. Common stock (5,000 × 15) = $75,000
[Credit]. Premium on common stock = $33,420.50

Using the market value of stock method, the journal entry is:

[Debit]. Bonds payable = $100,000
[Debit]. Premium on bonds payable = $8,420.50
[Debit]. Loss on conversion = $16,579.50
[Credit]. Common stock = $75,000
[Credit]. Premium on common stock = $50,000
(Note: 5,000 × $25 = $125,000)

Using the market value of the bond method, the journal entry is:

[Debit]. Bonds payable = $100,000
[Debit]. Premium on bonds payable = $8,420.50
[Debit]. Loss on conversion = $11,579.50
[Credit]. Common stock = $75,000
[Credit]. Premium on common stock = $45,000
(Note: $100,000 × 120% = $120,000)

 

As mentioned at the beginning of this post; bonds payable is only one of many concern that a controller should consider about accounting for liabilities. There are still huge issues to be considered, for example: debt may be extinguished prior to the maturity date when the company can issue new debt at a lower interest rate, estimated liabilities must be recognized when it is probable that an asset has been impaired or liability has been incurred by year-end, and the amount of loss can be reasonably estimated, an accrued liability may be recognized for future absences, for example, sick leave or vacation time, special termination benefits such as early retirement may also be offered to and accepted by employees, short-term debt may be rolled over to long-term debt, requiring special reporting, a callable obligation by the creditor may exist, long-term purchase obligations have to be disclosed, and many more.