Accounting Treatment for Debt [with Examples]

Accounting Treatment for DebtThere are a number of accounting issues related to debt that the accountant is likely to face. For example, how should one account for the early retirement of debt, a change in the terms of a debt agreement, the presence of a discount or premium on the sale of bonds, or the use of warrants? In this post, I try to address all these common issues, as well as others related to defaulted debt, callable debt, sinking funds, debt that has been converted to equity, debt re-financings, and non-cash debt payments. Enjoy!

 

 
What is Bond?

The typical bond is a long-term (1 to 30 year) obligation to pay a creditor, and which may be secured by company assets. A traditional bond agreement calls for a semi-annual interest payment, while the principal amount is paid in a lump sum at the termination date of the bond. The issuing company may issue periodic interest payments directly to bond holders, though only if they are registered; another alternative is to send the entire amount of interest payable to a trustee, who exchanges bond coupons from bond holders for money from the deposited funds.

The issuing company frequently creates a “sinking fund” well in “advance of the bond pay-off date“, so that it will have sufficient funds available to make the final balloon payment (or buy back bonds on an ongoing basis). The bond agreement may contain a number of restrictive covenants that the company must observe, or else the bond holders will be allowed a greater degree of control over the company or allowed to accelerate the payment date of their bonds.

A bond will be issued at a stated face “value interest rate“. If this rate does not equate to the market rate on the date of issuance, then investors will either bid up the price of the bond (if its stated rate is higher than the market rate) or bid down the price (if its stated rate is lower than the market rate). The after-market price of a bond may subsequently vary considerably if the market rate of interest varies substantially from the stated rate of the bond.

Some bonds are issued with no interest rate at all. These “zero-coupon bonds” are sold at a deep discount and are redeemed at their face value at the termination date of the bond. They are of particular interest to those companies that do not want to be under the obligation of making fixed interest payments during the term of a bond.

The interest earned on a bond is subject to income taxes, except for those bonds issued by government entities. Theses bonds, known as “municipal bonds“, pay tax-free interest. For this reason, they can be competitively sold at lower actual interest rates than the bonds offered by commercial companies.

The serial bond does not have a fixed termination date for the entire issuance of bonds. Instead, the company is entitled to buy back a certain number of bonds at regular intervals, so that the total number of outstanding bonds declines over time.

The “convertible bond” contains a feature that allows the holder to turn in the bond in exchange for stock when a pre-set strike price for the stock is reached. An alternative is the use of attached warrants, which allow the bond holder to buy shares of company stock at a pre-specified price. If the warrants are publicly traded, then their value can be separated from that of the bond, so that each portion of the package is recognized separately in a company’s balance sheet.

 

 
Basic Bond Transactions

Though some corporations issue their own bonds directly to investors, it is much more common to engage the services of an investment banker, who not only lines up investors for the company, but who may also invest a substantial amount of its own funds in the company’s bonds. In either case, the Board of Directors must approve any new bonds, after which a trustee is appointed to control the bond issuance, certificates are printed and signed, and delivery is made to either the investment banking firm or directly to investors in exchange for cash.

When bonds are initially sold, the entry is a debit to cash and a credit to bonds (or notes) payable. If the bonds are sold at a discount, then the entry will include a debit to a discount on bonds payable account.

Case Example

$10,000 of bonds are sold at a discount of $1,500, the entry would be:

[Debit]. Cash = $8,500
[Credit]. Discount on bonds payable = $1,500
[Credit]. Bonds payable = $10,000

If the same transaction were to occur, with the exception that a premium on sale of the bonds were to occur, then the entry would be:

[Debit]. Cash = $11,500
[Credit]. Premium on bonds payable = $1,500
[Credit]. Bonds payable = $10,000

 
The costs associated with issuing bonds can be substantial. These include the legal costs of creating the bond documents, printing the bond certificates, and (especially) the underwriting costs of the investment banker. Since these costs are directly associated with the procurement of funds that the company can be expected to use for a number of years (until the bonds are paid off), the related bond issuance costs should be recorded as an asset and then written off on a straight-line basis over the period during which the bonds are expected to be used by the company. This entry is a debit to a bond issuance asset account and a credit to cash. However, if the bonds associated with these costs are subsequently paid off earlier than anticipated, one can reasonably argue that the associated remaining bond issuance costs should be charged to expense at the same time.

 

 
Accounting For Bond Premium or Discount

As noted in the last section, investors may purchase bonds at a reduced price if the market interest rate is greater than the stated rate on the bonds, or at an increased price if the reverse is true.

 

Case Example

The Lie Dharma Security Company issues $1,000,000 of bonds at a stated rate of 8% in a market where similar issuances are being bought at 11%. The bonds pay interest once a year, and are to be paid off in 10 years. Investors purchase these bonds at a discount in order to earn an effective yield on their investment of 11%. The discount calculation requires one to determine the present value of 10 interest payments at 11% interest, as well as the present value of $1,000,000, discounted at 11% for 10 years.

The result is:

Present value of 10 payments of $80,000 = $ 80,000 x 5.8892 =  $ 471,136
Present value of $1,000,000 = $1,000,000 x 0.3522                  =  $ 352,200
                                                                                                   = $ 823,336
Less: stated bond price                                                               = $1,000,000
Discount on bond                                                                       = $   176,664

 

In this example, the entry would be a debit to Cash for $823,336, a credit to Bonds Payable for $1,000,000, and a debit to Discount on Bonds Payable for $176,664. If the calculation had resulted in a premium (which would only have occurred if the market rate of interest was less than the stated interest rate on the bonds), then a credit to Premium on Bonds Payable would be in order.

The amount of a discount should be gradually written off to the interest expense account over the life of the bond, while the amount of a premium should be written off in a similar manner to the interest income account. The only acceptable method for writing off these accounts is through the interest method, which allows one to charge off the difference between the market and stated rate of interest to the existing discount or premium account. To continue with our example, the interest method holds that, in the first year of interest payments, the Lie Dharma Security Company’s accountant would determine that the market interest expense for the first year would be $90,567 (bond stated price of $1,000,000 minus discount of $176,664, multiplied by the market interest rate of 11%).

The resulting journal entry would be:

[Debit]. Interest expense = $90,567
[Credit]. Discount on bonds payable = $10,567
[credit]. Interest payable = $80,000

 

The reason why only $80,000 is listed as interest payable is that the company only has an obligation to pay an 8% interest rate on the $1,000,000 face value of the bonds, which is $80,000. The difference is netted against the existing Discount on Bonds Payable account.

When reporting this information in the financial statements, the amount of the discount or premium should be combined with the face value of bonds outstanding, though it is also acceptable to note the amount of the discount or premium in an attached footnote.

 

 
Accounting For Non-Interest Bearing Note Payable

If a company issues debt that has no stated rate of interest, then the accountant must create an interest rate for it that approximates the rate that the company would likely obtain, given its credit rating, on the open market on the date when the debt was issued. The accountant then uses this rate to discount the face amount of the debt down to its present value, and then records this present value as the loan balance.

Case Example

A company issued debt with a face amount of $1,000,000, payable in five years and at no stated interest rate, and the market rate for interest at the time of issuance was 9%, then the discount factor to be applied to the debt would be 0.6499. This would give the debt a present value of $649,900, at which it should be recorded. The difference between the face amount of $1,000,000 and the present value of $649,900 should be recorded as interest expense payable, with that portion of the expense due within the next year being recorded as a current liability and the remainder as a long-term liability.

 

 
Accounting For Non-Cash Debt Payment

In some cases where the issuing company is unable to pay bond holders, it gives them other company assets in exchange for the interest or principal payments owed to them.  When this occurs, the issuing company records a gain or loss on the transaction if there is a difference between the carrying value of the debt being paid off and the fair market value of the asset being transferred to the bond holder.

 

 
Accounting For Early Debt Retirement

A company may find it advisable to repurchase its bonds prior to their maturity date, perhaps because market interest rates have dropped so far below the stated rate on the bonds that the company can profitably refinance at a lower interest rate. Whatever the reason may be, the resulting transaction should recognize any gain or loss on the transaction, as well as recognize the transactional cost of the retirement, and any proportion of the outstanding discount, premium, or bond issuance costs relating to the original bond issuance.

Case Example

To return to our earlier example, if the Lie Dharma Security Company were to buy back $200,000 of its $1,000,000 bond issuance at a premium of 5%, and does so with $125,000 of the original bond discount still on its books, it would record a loss of $10,000 on the bond retirement (=$200,000 x 5%), while also recognizing one fifth of the remaining discount, which is $25,000 (=$125,000 x 1/5).

The entry would be:

[Debit]. Bonds payable = $200,000
[Debit]. Loss on bond retirement = $10,000
[Credit]. Discount on bonds payable = $25,000
[Credit]. Cash = $185,000

 

Any gain or loss resulting from this early retirement must be recorded in current income. If the amount is material, it should be recorded as an extraordinary item, net of any related income tax effect. Accompanying this information should be a notation in the financial statements that describes the sources of funds used to purchase the debt, as well as the related income tax effect and the per-share impact of the transaction.

 

 
Accounting For Callable Debt

If a debt can be called by the creditor, then it must be classified as a current liability.

However:

  • if the period during which the creditor can call the debt is at some point subsequent to one year, then it may still be classified as a long-term debt;
  • also, if the call option only applies if the company defaults on some performance measure related to the debt, then the debt only needs to be classified as a current liability if the company cannot cure the performance measure within whatever period is specified under the terms of the debt;
  • further, if a debt agreement contains a call provision that is likely to be activated under the circumstances present as of the balance sheet date, then the debt should be classified as a current liability; conversely, if the probability of the call provision being invoked is remote, then the debt does not have to be so classified;
  • finally, if only a portion of the debt can be called, then only that portion need be classified as a current liability.

 

 
Accounting For Defaulted Debt

If the issuing company finds itself in the position of being unable to pay either interest or principal to its bond holders, there are two directions the accountant can take in reflecting the problem in the accounting records. In the first case, the company may only temporarily be in default, and is attempting to work out a payment solution with the bond holders.

Under this scenario, the amortization of discounts or premiums, as well as of bond issuance costs and interest expense, should continue as they have in the past. However:

  • If there is no chance of payment, then the amortization of discounts or premiums, as well as of bond issuance costs, should be accelerated, being recognized in full in the current period. This action is taken on the grounds that the underlying accounting transaction that specified the period over which the amortizations occurred has now disappeared, requiring the accountant to recognize all remaining expenses.
  • If the issuing company has not defaulted on a debt, but rather has restructured its terms, then the accountant must determine the present value of the new stream of cash flows and compare it to the original carrying value of the debt arrangement. In the likely event that the new present value of the debt is less than the original present value, the difference should be recognized in the current period as an extraordinary gain.
  • Alternatively, if the present value of the restructured debt agreement is more than the carrying value of the original agreement, then a loss is not recognized on the difference—instead, the effective interest rate on the new stream of debt payments is reduced to the point where the resulting present value of the restructured debt matches the carrying value of the original agreement. This will result in a reduced amount of interest expense being accrued for all future periods during which the debt is outstanding.

 

 
Accounting For Short-Term Debt Being Refinanced

It is generally not allowable to reclassify a debt that is coming due in the short term as a long-term liability on the grounds that it is about to be refinanced as a long-term debt. This treatment would likely result in no debt ever appearing in the current liabilities portion of the balance sheet. This treatment is only allowable if the company intends to refinance the debt on a long-term basis, rather than simply rolling over the debt into another short-term debt instrument that will, in turn, become due and payable in the next accounting year.

Also, there must be firm evidence of this roll-over into a long-term debt instrument, such as the presence of a debt agreement or an actual conversion to long-term debt subsequent to the balance sheet date.

 

 
Accounting For Warrants Sold With Bonds

A company may attach warrants to its bonds in order to sell the bonds to investors more easily. A warrant gives an investor the right to buy a specific number of shares of company stock at a set price for a given time interval.

To account for the presence of a warrant, the accountant must determine its value if it were sold separately from the bond, determine the proportion of the total bond price to allocate to it, and then credit this proportional amount into the additional paid-in capital account.

Case Example

A bond/warrant combination is purchased by an investor at its stated value of $1,000. The investment banker handling the transaction estimates that the value of the warrant is $50, and that the bond would have sold for $980 if the warrant had not been attached to it. Accordingly, the value the accountant assigns to the warrant is $48.54, which is calculated as follows:

Price assigned to warrant:

= [Warrant value / Bond value + Warrant value] x Purchase price

= [$50/$980 + $50] x $1,000 = $48.54

 

The accountant then credits the $48.54 assigned to the warrant value to the additional paid-in capital account, since this is a form of equity funding, rather than debt funding, for which the investor has paid.

 

 
Accounting For Bond Conversion To Equity

If a company issues bonds that are convertible to stock, then bond holders may either convert the bonds to stock on specific dates or (more commonly) at any date, but only at a specific conversion price per share, which is typically set at a point that makes the transaction uneconomical unless the share price rises at some point in the future.

To account for this transaction, the principal amount of the bond is moved to an equity account, with a portion being allocated to the capital account at par value and the remainder going to the additional paid-in capital account. A portion of the discount or premium associated with the bond issuance is also retired, based on the proportion of bonds converted to equity.

Case Example

A bond holder owns $50,000 of bonds and wishes to convert them to 1,000 shares of company stock that has a par value of $5. The total amount of the premium associated with the original bond issuance was $42,000, and the amount of bonds to be converted to stock represents 18% of the total amount of bonds outstanding. In this case, the amount of premium to be recognized will be $7,560 (=$42,000 x 18%), while the amount of funds shifted to the Capital Stock at Par Value account will be $5,000 (=1,000 shares x $5).

The entry is:

[Debit]. Bonds payable = $50,000
[Debit]. Premium on bonds payable = $7,560
[Credit]. Capital stock at par value = $5,000
[Credit]. Additional paid-in capital = $52,560

 

 
Accounting For Sinking Funds

A bond agreement may contain specific requirements to either create a sinking fund that is used at the maturity date to buy back all bonds, or to gradually buy back bonds on a regular schedule, usually through a trustee. In either case, the intention is to ensure that the company is not suddenly faced with a large repayment requirement at the maturity date.

In this situation, the company usually forwards funds, at regular intervals, to a trustee who in turn uses the funds to buy back bonds. The resulting accounting is identical to that noted under the “Accounting for Early Debt Retirement” section. In addition, if the company forwards interest payments to the trustee for bonds that the trustee now has in its possession, these payments are used to purchase additional bonds (since there is no one to whom the interest can be paid). In this case, the journal entry that would normally record this transaction as interest expense is converted into an entry that reduces the principal balance of the bonds outstanding.

 

Among all accounting treatment related to debt topics, a few key issues arise:

First, debt must always be recorded at the market interest rate, which may involve the use of present value discounting or the use of discounts or premiums from the stated face value of a bond; this principle is designed to give the reader of a financial statement a clear idea of the true cost of a company’s debt.

Second, any debt origination costs associated with a debt should be amortized over the life of the debt, so that the cost is matched to the underlying benefit—that of having obtained the debt.

Third, if there is a reasonable expectation that a debt may be due and payable within one year, then it must be listed as a current liability—this clearly identifies the risk that debt may be payable in the short term, which may potentially result in a cash flow problem.

Finally, any change in the terms of a debt agreement that results in a gain or loss should be recognized at once, either through monetary recognition or footnotes, so that one can readily see its long-term financial impact. Thus, the key issues involving debt are the clear presentation of the cost and timing of debt liabilities.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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