Accounting For Bonds Payable
This $31,470 must be expensed over the life of the bond; uniformly spreading the $31,470 over 10 six-month periods produces periodic interest expense of $3,147 (not to be confused with the actual periodic cash payment of $4,000). Here is a comparison of the 10 interest payments if a company’s contract rate is more than the market rate. Here is a comparison of the 10 interest payments if a company’s contract rate is less than the market rate. It is also the same as the price of the bond, and the amount of cash that the issuer receives. On maturity, the book or carrying value will be equal to the face value of the bond. Both of these statements are true, regardless of whether issuance was at a premium, discount, or at par.
Bonds are loans made by smaller lenders, such as other corporations and individual people. A corporation may borrow from many different smaller investors and collectively raise the amount of cash it needs. Corporate bonds are traded on the bond market similar to the way corporate stock is traded on the stock market. They are long- term liabilities for most of their life and only become current liabilities as of one year before their maturity date. Another way to consider this problem is to note that the total borrowing cost is increased by the $7,722 discount, since more is to be repaid at maturity than was borrowed initially. This topic is inherently confusing, and the journal entries are actually clarifying.
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The 8% market rate of interest equates to a semiannual rate of 4%, the 6% market rate scenario equates to a 3% semiannual rate, and the 10% rate is 5% per semiannual period. The second way to amortize the discount is with the effective interest method. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period. Bonds may also be issued during a calendar year rather than on January 1. They may also be redeemed during a calendar year rather than on December 31.
There are times when the contract rate that your corporation will pay is less than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be lower than what investors could receive elsewhere. To be competitive difference between horizontal and vertical analysis with comparison chart and still attract investors, the bond must be issued at a discount. This means the corporation receives less cash than the face amount of the bond when it issues the bond. The corporation still pays the full face amount back to the bondholders on the maturity date.
Example of the Discount on Bonds Payable
Since the adjusting entries to amortize the discount or premium occur on December 31 of each calendar year, it will be necessary to pro-rate the amortization amount to properly reflect the time during the year that the bond was held. Notice on the ledger at the right below that each time the end-of-year adjusting entry is posted, the debit balance of the Discount on Bonds Payable decreases. As a result, the carrying amount increases and gets closer and closer to face amount over time. Issuing bonds – A journal entry is recorded when a corporation issues bonds.
- It is important to note that a gain or loss is incurred on a transaction that is outside of what occurs in normal business operations and therefore is not categorized as an operating revenue or expense.
- At every coupon payment, interest expense will be incurred on the bond.
- There are times when the contract rate that your corporation will pay is less than the market rate that other corporations will pay.
- The following four examples show bonds at both a discount and a premium that are called at both a gain and a loss.
- The present value factors are taken from the present value tables (annuity and lump-sum, respectively).
The corporation will still pay bondholders the $100,000 face amount at the end of the five-year term. Another way to illustrate this problem is to note that total borrowing cost is reduced by the $8,530 premium, since less is to be repaid at maturity than was borrowed up front. One simple way to understand bonds issued at a premium is to view the accounting relative to counting money! If Schultz issues 100 of the 8%, 5-year bonds when the market rate of interest is only 6%, then the cash received is $108,530 (see the previous calculations). Schultz will have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity).
When a corporation is preparing a bond to be issued/sold to investors, it may have to anticipate the interest rate to appear on the face of the bond and in its legal contract. Let’s assume that the corporation prepares a $100,000 bond with an interest rate of 9%. Just prior to issuing the bond, a financial crisis occurs and the market interest rate for this type of bond increases to 10%. If the corporation goes forward and sells its 9% bond in the 10% market, it will receive less than $100,000.
When a bond is sold for less than its face amount, it is said to have been sold at a discount. The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the terms discount on bonds payable, bond discount, or discount.
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However, if a bond is redeemed mid-year, an adjusting entry is recorded to bring the carrying up to date as of the date of redemption. Let’s say you purchase an airline ticket from Atlanta to San Francisco for $400. While in flight, you learn that the person sitting next to you paid $250 for the same flight. You would probably feel badly and a little cheated for having paid too much.
On the flip side, you would feel pretty pleased if you were the one who paid $250 rather than the other passenger’s $400 fare. That is similar to a gain on redemption of bonds, when you pay less than carrying amount to redeem a bond. The carrying value of a bond is not equal to the bond payable amount unless the bond was issued at par. In all the previous examples, bonds were issued on January 1 and redeemed on December 31 several years later. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.
There are times when the contract rate that your corporation will pay is more than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be higher than what investors could receive elsewhere. Since its future interest payments will be higher in comparison to other https://www.bookkeeping-reviews.com/difference-between-llc-and-llp/ bonds on the market, the corporation can command a higher amount up front when the bond is issued, and the bond is sold at a premium. This means the corporation receives more cash than the face amount of the bond when it issues the bond. The corporation still pays the face amount back to the bondholders on the maturity date.
The bonds have a term of five years, so that is the period over which ABC must amortize the discount. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0. Reducing this account balance in a logical manner is known as amortizing or amortization.
Since a bond’s discount is caused by the difference between a bond’s stated interest rate and the market interest rate, the journal entry for amortizing the discount will involve the account Interest Expense. In this case, the corporation is offering a 12% interest rate, or a payment of $6,000 every six months, when other companies are offering an 11% interest rate, or a payment of $5,500 every six months. As a result, the corporation will pay out $60,000 in interest over the five-year term. Comparable bonds on the market will pay out $55,000 over this same time frame. In this case, the corporation is offering an 11% interest rate, or a payment of $5,500 every six months, when other companies are offering a 12% interest rate, or a payment of $6,000 every six months. As a result, the corporation will pay out $55,000 in interest over the five-year term.
The difference between the amount received and the face or maturity amount is recorded in the corporation’s general ledger contra liability account Discount on Bonds Payable. This amount will then be amortized to Bond Interest Expense over the life of the bonds. Discount on bonds payable occurs when a bond’s stated interest rate is less than the bond market’s interest rate. The format of the journal entry for amortization of the bond discount is the same under either method of amortization – only the amounts recorded in each period will change. The issue price is the amount of cash collected from bondholders when the bond is sold. Cash is debited for the amount received from bondholders; the liability (debt) from bonds increases for the face amount.
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