Bonds – Review

(Chapter 14)

Bonds Payable
1. (S.O. 2) Bonds payable represent an obligation of the issuing corporation to pay a sum of money
at a designated maturity date plus periodic interest at a specified rate on the face value.
2. Bonds are debt instruments of the issuing corporation used by that corporation to borrow funds
from the general public or institutional investors. The use of bonds provides the issuer an
opportunity to divide a large amount of long-term indebtedness among many small investing
units.
3.(S.O. 3) Bonds are issued with a stated rate of interest expressed as a percentage of the face
value of the bonds. When bonds are sold for more than face value (at a premium) or less than
face value (at a discount), the interest rate actually earned by the bondholder is different from
the stated rate. This is known as the effective yield or market rate of interest and is set by
economic conditions in the investment market. The effective rate exceeds the stated rate when
the bonds sell at a discount, and the effective rate is less than the stated rate when the bonds
sell at a premium.
Valuation of Bonds
The price of a bond is determined by the interaction between the bond’s stated interest rate and
its market rate.
a. A bond’s price is equal to the sum of the present value of the principal and the present
value of the periodic interest.
b. If the stated rate = the market rate, the bond will sell at par.
c. If the stated rate < the market rate, the bond will sell at a discount.
d. If the stated rate > the market rate, the bond will sell at a premium.

Discounts and Premiums

4. (S.O. 4) Discounts and premiums resulting from a bond issue are recorded at the time the bonds
are sold. The amounts recorded as discounts or premiums are amortized each time bond
interest is paid. The time period over which discounts and premiums are amortized is equal to
the period of time the bonds are outstanding (date of sale to maturity date). Amortization of bond
premiums decreases the recorded amount of bond interest expense, whereas the amortization
of bond discounts increases the recorded amount of bond interest expense.
a. The face value of the bond is always reflected in the Bonds Payable account.
b. When a bond sells at a discount, the difference between the sales price and the face value is
debited to Discount on Bonds Payable (This is a contra-account to Bonds Payable)
c. When a bond sells at a premium, the difference between the sales price and the face value
is credited to Premium on Bonds Payable (This is an adjunct account to Bonds Payable)
d. Bonds sold between interest dates
(1) The price includes the interest accrued since the last interest payment date
(2) The accrued interest is credited to Bond Interest Expense.
e. The amortization period for premiums or discounts is the period of time that the bonds are
expected to be outstanding.
f. Bond interest expense is increased by amortization of a discount and decreased by amortization
of a premium.
5.To illustrate the recording of bonds sold at a discount or premium the following examples are
presented. If Aretha Company issued $100,000 of bonds dated January 1, 2010 at 98, on January 1,
2010, the entry would be as follows:

Cash ($100,000 X .98) .................................. 98,000

Discount on Bonds Payable .......................... 2,000
Bonds Payable ......................................... 100,000

If the same bonds noted above were sold for 102 the entry to record the issuance would be as
follows:

Cash ($100,000 X 1.02) ................................ 102,000

Premium on Bonds Payable ..................... 2,000
Bonds Payable ......................................... 100,000

It should be noted that whenever bonds are issued, the Bonds Payable account is always
credited for the face amount of the bonds issued.

6. To illustrate the amortization of the bond discount or premium, assume the bonds sold in the
example in paragraph 10 above are five-year bonds. Since the bonds are sold on the issue date
(January 1, 2010) they will be outstanding for the full five years. Thus, the discount or premium
would be amortized over the entire life of the bonds. The entry to amortize the bond discount at
the end of 2010 would be:

Bond Interest Expense .................................. 400

Discount on Bonds Payable ($2,000/5) .... 400

The entry to amortize the premium would be:

Premium on Bonds Payable .......................... 400

Bond Interest Expense ............................ 400

Note that the amortization of the discount increases the bond interest expense for the period and
the amortization of the premium reduces bond interest expense for the period.

7. When bonds are issued between interest dates, the purchase price is increased by an amount
equal to the interest earned on the bonds since the last interest payment date. On the next
interest payment date, the bondholder receives the entire semiannual interest payment.
However, the amount of interest expense to the issuing corporation is the difference between
the semiannual interest payment and the amount of interest prepaid by the purchaser. For
example, assume a 10-year bond issue in the amount of $300,000, bearing 9% interest payable
semiannually, dated January 1, 2010. If the entire bond issue is sold at par on March 1, 2010, the
following journal entry would be made by the seller:

Cash .............................................................. 304,500

Bonds Payable ......................................... 300,000
Bond Interest Expense ............................. 4,500*
*($300,000 X .09 X 2/12)
The entry for the semiannual interest payment on July 1, 2010 would be as follows:

Bond Interest Expense .................................. 13,500

Cash ......................................................... 13,500

The total bond interest expense for the six month period is $9,000 ($13,500 – $4,500), which
represents the correct interest expense for the four-month period the bonds were outstanding.

8. Bond discounts or premiums may be amortized using the straight-line method, as was
demonstrated above. However, the profession’s preferred procedure is the effective-interest
method. This method computes the bond interest using the effective rate at which the bonds are
issued. More specifically, interest cost for each period is the effective interest rate multiplied by
the carrying value (book value) of the bonds at the start of the period. The effective-interest
method is best accomplished by preparing a Schedule of Bond Interest Amortization. This schedule
provides the information necessary for each semiannual entry for interest and discount or premium
amortization.
(1) Carrying Value of Bonds = Face Value Plus Premium (or Less Discount)
(2) Interest Payable = Stated Interest Rate X Face Value of Bonds
(3) Interest Expense = Effective Interest Rate X Carrying Value of Bonds
(4) If a premium exists:
Interest Expense XX
Premium on Bonds Payable XX
Interest Payable XX
(5) If a discount exists:
Interest Expense XX
Discount on Bonds Payable XX
Interest Payable XX
Straight-line method of amortization may be used if the results are not materially different from
those produced by the effective-interest method.

9. Unamortized premiums and discounts are reported with the Bonds Payable account in the liability
section of the balance sheet. Premiums and discounts are not liability accounts; they are merely
liability valuation accounts. Premiums are added to the Bonds Payable account and discounts
are deducted from the Bonds Payable account in the liability section of the balance sheet.

10. If the interest payment date does not coincide with the financial statement’s date, the amortized
premium or discount should be prorated by the appropriate number of months to arrive at the
proper interest expense.

11. Some of the costs associated with issuing bonds include engraving and printing costs, legal and
accounting fees, commissions, and promotion expenses. APB Opinion No. 21, “Interest on
Receivables and Payables,” indicates that these costs should be debited to a deferred charge
account entitled, Unamortized Bond Issue Costs. These costs are then amortized over the life
of the issue, usually using the straight-line method.
Extinguishment of Debt
12. (S.O. 5) The extinguishment, or payment, of long-term liabilities can be a relatively straightforward
process which involves a debit to the liability account and a credit to cash. The process can also
be a complicated one when the debt is extinguished prior to maturity.

13. The reacquisition of debt can occur either by payment to the creditor or by reacquisition in the
open market. At the time of reacquisition, any unamortized premium or discount, and any costs
of issue related to the bonds, must be amortized up to the reacquisition date. If this is not done
any resulting gain or loss on the extinguishment would be misstated. The difference between the
reacquisition price and the net carrying amount of the debt is a gain (reacquisition price lower) or
loss (reacquisition price greater).

14. The difference between the net carrying amount and the reacquisition price is a gain or loss
a. Reacquisition price = price + call premium + reacquisition expenses
b. Carrying amount = face value ± unamortized premium/discount + unamoritized issuance costs
c. Gain on Redemption of Bonds: when carrying amount > reacquisition price
d. Loss on Redemption of Bonds: when carrying amount < reacquisition price