Accounting for Bonds For your main Discussion post, share your understanding of
ID: 2584906 • Letter: A
Question
Accounting for Bonds
For your main Discussion post, share your understanding of bonds as a form of financing a corporation. Discuss how the price of a bond is determined and provide an example of each of the following:
• A bond issued at a premium,
• A bond issued at par,
• A bond issued at a discount.
Additionally, provide the journal entry that would be made to record each of your bond examples as well as the first journal entry that would be made to amortize each of the bond’s premium and discount. What would be the Net Bond Value after the first amortization entry for each of your example bonds? In your main post, also comment on the circumstances upon which a bond may be callable and when a bond may be convertible.
Explanation / Answer
How price of bond is determined?
A bond is a debt instrument: it pays periodic interest payments based on the stated (coupon) rate and return the principal at the maturity.
Cash flows on a bond with no embedded options are fairly certain and the price of bond equals the present value of future interest payments plus the present value of the face value (which is returned at maturity) based on the interest rate prevailing in the market.
The present value of interest payments is calculated using the formula for present value of an annuity and the present value of the face value (also called the maturity value) is calculated using the formula for present value of a single sum occurring in future.
If r is the interest rate prevailing in the market, c is the coupon rate on the bond, t is the time periods occurring over the term of the bond and F is the face value of the bond, the present value of interest payments is calculated using the following formula:
Present Value of Interest Payments = c × F ×
1 (1 + r)-t
r
The present value of the face value (i.e. the maturity value) is calculated as follows:
Present Value of Face Value of a Bond =
F
(1+r)t
Therefore, the price of a bond is given by the following formula:
Present Value of Interest Payments = c × F ×
1 (1 + r)-t
+
F
r
(1 + r)t
Bonds issued at a premium When we issue a bond at a premium, we are selling the bond for more than it is worth. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable. Just like with a discount, we will remove the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual interest payment.
For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 105 1/4 or 105.25% with interest to be paid semi-annually on June 30 and December 30 for cash. We know this is a discount because the price is less than 100%. The entry to record the issue of the bond on January 1 would be:
Debit
Credit
Jan 1
Cash ($100,000 x 105.25%)
105,250
Premium on Bonds Payable ($105,250 cash – $100,000 bond)
5,250
Bonds Payable ($100,000 bond amount)
100,000
To record issue of bond at a premium.
The carrying value of these bonds at issuance is equal to the cash received of $105,250, consisting of the face value of $100,000 and the premium of $5,250. The premium is an adjunct account shown on the balance sheet as an addition to bonds payable as follows:
Long-term Liabilities:
Bonds Payable, 12% due in 3 years
$100,000
Plus: Premium on Bonds Payable
5,250
$105,250
Remember, when a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. A premium decreases the amount of interest expense we record semi-annually. In our example, the bond pays interest every 6 months on June 30 and December 31. We will amortize the premium using the straight-line method meaning we will take the total amount of the premium and divide by the total number of interest payments. In this example the premium amortization will be $5,250 discount amount / 6 interest payment (3 years x 2 interest payments each year). The entry to record the semi-annual interest payment and discount amortization would be:
Debit
Credit
Jun 30
Bond Interest Expense ($6,000 cash interest – 875 premium amortization)
5,125
Premium on Bonds Payable ($5,250 premium / 6 interest payments)
875
Cash ($100,000 x 12% x 6 months / 12 months)
6,000
To record period interest payment and premium amortization.
Bonds issued at a discount When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable. This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment
For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 95 1/2 or 95.50% with interest to be paid semi-annually on June 30 and December 30 for cash. We know this is a discount because the price is less than 100%. The entry to record the issue of the bond on January 1 would be:
Debit
Credit
Jan 1
Cash ($100,000 x 95.5%)
95,500
Discount on Bonds Payable ($100,000 bond – $95,500 cash)
4,500
Bonds Payable ($100,000 bond amount)
100,000
To record issue of bond at a discount.
In the balance sheet, the bonds would be reported with a carrying value equal to the cash received of $95,500 reported as:
Long-term Liabilities:
Bonds Payable, 12% due in 3 years
$100,000
Less: Discount on Bonds Payable
(4,500)
$95,500
When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. The bond pays interest every 6 months on June 30 and December 31. We will amortize the discount using the straight-line method meaning we will take the total amount of the discount and divide by the total number of interest payments. In this example the discount amortization will be $4,500 discount amount / 6 interest payment (3 years x 2 interest payments each year). The entry to record the semi-annual interest payment and discount amortization would be:
Debit
Credit
Bond Interest Expense
6,750
Discount on Bonds Payable ($4,500 / 6 interest payments)
750
Cash ($100,000 x 12% x 6 months / 12 months)
6,000
To record periodic interest payment and discount amortization.
Bond is issued at par:
For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 100 100% with interest to be paid semi-annually on June 30 and December 30 for cash. We know this is at par because the price is equal to 100%. The entry to record the issue of the bond on January 1 would be
Debit
Credit
Jan 1
Cash
100,000
Bonds Payable
100,000
To record issue of bond at par.
Amortization entry: Debit Credit
Bond Interest Expense 6000
Cash($100,000 x 12% x 6 months / 12 months) 6000
To record periodic interest payment and discount amortization
The carrying value of bonds payable In the balance sheet remains the same if bond are issued at par i.e. 100000
Present Value of Interest Payments = c × F ×
1 (1 + r)-t
r