Accounting for Debt Investments

Overview of Debt Investments

One form of investment is debt investment, as in bonds or notes, which are short-term or long-term and return periodic interest to the owner.

From an accounting perspective, a bond as a debt investment itself is an asset that returns cash in the form of interest payments, which triggers the recognition of interest revenue. Typically, bond interest payments (usually annual or semiannual) belong to the bondholder of record on the stipulated payment date. Bond purchase dates do not always coincide with the stipulated bond interest payment dates. This disconnection between the interest payment dates and the purchase date of the bond investment can be resolved.

When a new investor purchases a bond instrument, the investor must pay for the bond instrument and pay for any accrued interest on the bond as of the purchase date. This accrued interest amount is returned to the investor upon receipt of the cash interest payment on the date of the face of the bonds.

Bonds Held to Maturity (HTM)

Journal entries for an initial bond investment and for the periodic interest payments for the bonds are made as the bonds are held to their maturity.

A held-to-maturity (HTM) security is typically a bond or note, as these instruments may have features that may make them less liquid than others or for other reasons and are intended to be held to defined maturity dates. Purchases of bond investments that are held to maturity are recognized with a simple journal entry. The specific investment account title can vary from one organization to another, but in all cases it should be clear that the investment is a bond or other long-term investment.

For example, a 10-year, 10% interest rate, $100,000 long-term bond at par, which means face value of the bond, is purchased on January 1, 2018. Also, the bond pays interest annually on December 31. For accounting purposes in this example, the bond interest is accrued semiannually. A purchase journal entry would be made.

Purchase of Bonds Journal Entry

Date Account Debit Credit
1/1/2018 Investment in Bonds $100,000
Cash $100,000

After the purchase is recorded, the investment in bonds will accrue interest. Note that the payout of interest as stated on the bond is a separate and distinct operation from the accrual of revenue. The accrual of revenue occurs twice per year, while the annual interest payment is only made to the bond owner of record on December 31. On June 30 an adjusting entry is required.

June 30 Interest Revenue Journal Entry

Date Account Debit Credit
6/30/2018 Interest Receivable $5,000
Interest Revenue $5,000

Note that the principal of $100,000 multiplied by the annual interest rate of 10% times 6/12 months ($100,000×10%×6/12)\left(\$100{\rm{,}}000\times10\%\times6/12\right), as only half the year has passed, equals the $5,000 accrual amount. It is also possible to use days to accrue interest. Depending on the bond specifications, a denominator of 360 or 365 may be used if accruing interest daily.

At the end of the year, additional interest revenue would need to be accrued, but there is also the need to recognize receipt of a cash interest payment on December 31. Although these entries could be simplified into a single compound entry or broken out, the accounting result is the same using one or two entries.

Year-End Interest Receivable Journal Entry

Date Account Debit Credit
12/31/2018 Interest Receivable $5,000
Interest Revenue $5,000

Note that the principal of $100,000 multiplied by the annual interest rate of 10% times 6/12 months ($100,000×10%×6/12)\left(\$100{\rm{,}}000\times10\%\times6/12\right) equals the $5,000 accrual amount for the second half of the year. The receivable balance is now $10,000, which equals the annual amount of interest on the principal.

The year-end cash revenue receipt entry shows the conversion of the interest receivable into cash upon the company's receipt of the stipulated amount of the bond interest payment. This process of accrual, followed by year-end payment and collection, would continue throughout the time period in which the investor company holds the bond. If the bond is held to maturity, there would be the same set of entries for each of the 10 years the bond is held.

Year-End Cash Revenue Accrual Journal Entry

Date Account Debit Credit
12/31/2018 Cash $10,000
Interest Receivable $10,000

The receivable balance is now $0 as all the interest earned for this year has been collected.

Upon maturity of the bond, the investment itself is removed from the books, and the cash principal is returned to the investor, as the bond has been held to maturity.

Cash Principal Return Journal Entry

Date Account Debit Credit
1/1/2028 Cash $100,000
Investment in Bonds $100,000

The cash principal return entry recognizes the maturity of the bond. The balance of Investment in Bonds is now zero as the Cash debit cancels it out.

Bonds Sold Prior to Maturity

Journal entries are made for the sale of a bond investment when that sale occurs before the bond's maturity date.

Bonds may be sold prior to maturity, at dates that do not coincide with interest payment dates stipulated on the bond instrument. In that case, the accounting principle that governs the approach is that interest belongs to the investor of record. So, until the date of sale, the owner of the bond accrues and recognizes interest revenue and should be compensated for such accrued interest.

To illustrate this situation, a 10-year, 10% interest rate, $100,000 long-term bond at par was purchased on January 1, 2018. The bond pays interest annually on December 31. If this bond is sold on March 31, 2018, it is sold prior to the maturity date. Consider what the bond might be worth on March 31, 2018: It has a face value of $100,000 and has accrued 3 months of interest, which has not been paid to the owner (January 1, 2018–March 31, 2018). This interest has an apparent value of ($100,000×10%×3/12)\left(\$100{,}000\times10\%\times3/12\right), or $2,500. So, it makes sense that the owner would receive $102,500 for the bond if it is sold on March 31, as the interest earned to date is included in the selling price. An entry would be made for that.

Cash Principal Return and Accrued Interest Journal Entry

Date Account Debit Credit
3/31/2018 Cash $102,500
Investment in Bonds $100,000
Interest Revenue $2,500

The key is to recognize the accrued interest up to the date of sale and to record that interest revenue on the books of the bond investment owner. The owner will receive all the interest payment, including the $2,500 earned by the previous owner.

Bonds Sold at a Premium

If an investment bond is offered for sale at a specific interest rate but the market rate for interest drops before the bond is sold, the bond will be sold at a premium above the bond’s face value.

A bond may be priced and sold above its face value. Companies purchasing these bonds are paying a premium. Most corporate bonds are sold with a face value of $1,000. This value represents the bond principal that will be paid to the bondholder upon maturity of the bond. For example, Corporation B issues a $50,000 bond offering, calculated from 50bonds×$1,00050\,\;{\text{bonds}}\times\$1{,}000, that consists of bonds paying 9% interest semiannually. However, just before the bonds hit the market, the current market rate for interest drops to 8%. So, when Corporation B's bonds begin to sell, investors purchase them, seeking a higher-paying 9% interest rate instead of the new current market rate of 8% for other comparable bonds. The investor’s demand for the higher 9% interest prices the bonds at a premium, an amount above their face value. The increase in the selling price is a rational reflection of a payment over the discount rate.

Assume the bonds sell at 105. Bond prices are quoted in percents: A quote of 100 is $1,000, meaning the price is 100% of the total $1,000. So a quote of 105 equals $1,050 per bond, or 105%×$1,000=$1,050105\%\times\$1{,}000 = \$1{,}050. Therefore, Corporation B will collect a total of $52,500 (minus brokerage fees) from selling the 50 bonds sold at $1,050 each, or 50×$1,050=$52,50050\times\$1{,}050 = \$52{,}500. Corporation B has gained a total extra premium cash of $2,500, calculated as $52,500$50,000=$2,500\$52{,}500 - \$50{,}000 = \$2{,}500.

Bond Amortization Table (Partial) for Bonds Sold at Premium

This amortization table assumes that 50 bonds were issued at $50,000 and initially sold for $52,500 (col. G), their book value. It shows the amounts used to calculate the book value, from 6/30/19 through 12/31/19. The book value is recalculated at each 6-month period by factoring in interest, fees, and premium (cols. B, C, D, E).

Bonds Sold at a Discount

A discount bond is priced below its original issuance price.

A discount bond's price is lower than the bond's original price when issued. For example, Corporation B issues a $10,000 bond offering that is comprised of bonds paying 10% interest, which is paid out twice per year. The bonds pay 5% interest for each semi-annual payment on January 1 and July 1 each year. However, just before the bonds are offered on the market, the current market rate for interest increases to 11%. Thus, the bond’s interest rate has fallen below the current market rate.

When Corporation B's bonds begin to sell, investors purchase the bonds, but they are not willing to pay the full original price because the interest rate of the bonds is lower than the interest rate of other bonds in the market. Consequently, Corporation B issues its bonds at 96.5, which means the investors pay only $965 per bond, instead of $1,000 per bond, for a total purchase amount of $9,650. The total discount on the entire Corporation B bond issue is $350. Therefore, the discount bond's price is discounted because it is lower than the bond's original issuance price.