Long-Term Liabilities

Accounting for Bonds Payable

Bonds Sold at a Discount

Bonds with a stated interest rate lower than market normally sell at a discount. The discount must be spread across the life of the bond using amortization entries.

The premium or discount on bonds and their subsequent amortization improves revenue and expense matching and spreads out these large differences in sale price over the life of the bond. For example, the town of Blue sold Series A bonds with a face amount of $50,000,000 and a stated rate of interest of 10% at 97. The bonds will mature in 30 years and pay the stated rate of interest semiannually (twice a year). These bonds would sell at 97% of face value, or $48,500,000. The difference of $1,500,000 is the discount on bonds payable. It is clear that the market rate of interest is greater than the stated rate of 10%, so buyers are only willing to pay less than full price.

An entry, to recognize this bond issuance on the town of Blue's books, is made with an assumption that the bond issue was on January 1.

Entry for Bond Sold at Discount

Date Account Debit Credit
1/1/2018 Cash $48,500,000
Discount on Bonds Payable $1,500,000
Bonds Payable $50,000,000

As part of the recognition of the bond discount over time, the amortization process begins by dividing the total discount by the life of the bonds. So, $1,500,000/30 years = $50,000 per year assuming the straight-line amortization method is used. This method is the simplest to calculate but is not the preferred method under U.S. generally accepted accounting principles (GAAP), which favors the amortized interest method. Blue would make an entry on June 30th to recognize the bond amortization and semiannual interest payment.

Discount Amortization Entry

Date Account Debit Credit
6/30/2018 Interest Expense (to balance) $2,525,000
*Discount on Bonds Payable $25,000
Cash $2,500,000
*

1,500,000 in total discount divided by 30 years and then multiplied by 6 out of 12 months

This process would continue through the end of the life of the bonds unless the bonds are retired (redeemed) early. Assume that after only 10 years, the town of Blue decides to retire the bonds. This is commonly done if better financing possibilities become available or market interest rates change. After 10 years, the original $1,500,000 discount would have been reduced by one third, since 10 of 30 years would have passed. The unamortized discount would be $1,000,000. The carrying amount of the bonds, that is, the face amount less any unamortized discount (or plus unamortized premium), would be $49,000,000. Notice that for bond discounts, the carrying amount of the bonds approaches the face amount as the bond is amortized.

To recognize the bond retirement, several things must be done:

1) Ensure amortization entries are up to date.

2) Remove the face value of the bonds from the books.

3) Remove any unamortized discount from the books.

4) Recognize any cash given up to retire the bonds.

5) Account for any other differences in order to balance the books.

The town of Blue now has the amortization entries up to date and has redeemed the bonds with cash. It would make an entry to retire the bonds.

Bond Retirement Entry

Date Account Debit Credit
12/31 of year 10 Bonds Payable $50,000,000
Discount on Bonds Payable $1,000,000
Cash $49,000,000

Bonds Sold at a Premium

Bonds with a stated interest rate higher than market normally sell at a premium. The premium must be spread across the life of the bond using amortization entries.

Bonds offering a stated rate of interest that is above market rates will sell at a premium since buyers will be willing to pay more to get the bonds. For example, the town of Blue sells its bonds at 103 instead of 97—a premium. The bonds have a face amount of $50,000,000, a 30-year life, and a stated rate of interest of 10% that pays semiannually. These bonds would sell at 103% of face value, or $51,500,000. The difference would be known as a premium on bonds payable. The market rate of interest is less than the stated rate of 10%, so buyers are willing to pay more than full price.

Assuming the bond issue was on January 1, an entry to recognize this issuance on the town of Blue’s books is made.

Entry for Bonds Sold at Premium

Date Account Debit Credit
1/1/2018 Cash $51,500,000
Premium on Bonds Payable $1,500,000
Bonds Payable $50,000,000

As part of the recognition of the bond premium over time, the amortization process begins by dividing the total premium by the life of the bonds: PV=$10,000,000/(1+0.10)30\mathrm{PV}=\$10\mathrm{,}000\mathrm{,}000/(1+0.10)^{30}.

The town of Blue makes an entry on June 30th to recognize the bond amortization and semiannual interest payment for a premium.

Entry for Premium Amortization

Date Account Debit Credit
6/30/2018 Interest Expense (to balance) $2,475,000
*Premium on Bonds Payable $25,000
Cash $2,500,000

*1,500,000 in total premium divided by 30 years and then multiplied by 6 out of 12 months

There is a difference in the interest expense debit. When the bonds were sold at a discount, the interest expense that flowed to the income statement was $2,525,000. The interest expense here, when the bonds are sold at a premium, is only $2,475,000. Amortizing a discount will increase the interest expense each period while amortizing a premium will reduce interest expense each period.

Again, the town of Blue chooses to retire the bonds early, after only 10 years have passed. After 10 years, the original $1,500,000 premium would have been reduced by one third, since 10 of 30 years would have passed. The unamortized premium would be $1,000,000. The carrying amount of the bonds (the face amount less any unamortized discount) would be $51,000,000. Notice that for bond premiums, the carrying amount of the bonds approaches the face amount each time the bond is amortized, coming down from a carrying value in excess of face amount.

The town of Blue makes an entry to retire the bonds early.

Early Retirement of Bonds Sold at a Premium

Date Account Debit Credit
12/31 of year 10 Bonds Payable $50,000,000
Premium on Bonds Payable $1,000,000
Cash $51,000,000

Bonds Sold at Face Amount

Selling the bonds in line with a market rate of interest yields no discount or premium.

Selling bonds with a stated rate above market yields a premium, and selling below yields a discount. However, if bonds are sold with the same rate as market, they are sold at face amount, with no discount or premium. Assume that the town of Blue sold its bonds with a face amount of $50,000,000 at 100, a stated rate of 10% (which is also what the market is currently yielding). These bonds would sell at 100% of face value, or $50,000,000.

In this example, the entry to recognize this issuance on the town of Blue's books is made, assuming the sale was on January 1.

Entry for Bonds Sold at Face Value

Date Account Debit Credit
1/1/2018 Cash $50,000,000
Bonds Payable $50,000,000

On June 30th, an entry is made to recognize the semiannual interest payment for a premium.

Entry for Bond Interest with No Discount or Premium

Date Account Debit Credit
6/30/2018 Interest Expense $2,500,000
Cash $2,500,000

Finally, assume these bonds are redeemed 10 years early. After 10 years, the bonds themselves would simply be redeemable for their face value without respect to premium or discount.

Entry to Retire Bonds Issued at Face Value

Date Account Debit Credit
12/31 of year 10 Bonds Payable $50,000,000
Cash $50,000,000