To
elaborate, if an individual wishes to borrow money he or she would typically
approach a bank or other lender. But, a corporate giant's borrowing needs may
exceed the lending capacity of any single bank or lender. Therefore, the large
corporate borrower may instead issue "bonds," thereby splitting a
large loan into many small units. For example, a bond issuer may borrow
$500,000,000 by issuing 500,000 individual bonds with a face amount of $1,000
each (500,000 X $1,000 = $500,000,000). If an individual wished to loan some
money to that corporate giant, he or she could do so by simply buying
("investing in") one or more of the bonds.
The
specifics of bonds will be covered in greater detail in a subsequent chapter,
where bonds are examined from the issuer's perspective (i.e., borrower). For
now bonds will be considered from the investor perspective. Each bond has a
"face value" (e.g., $1,000) that corresponds to the amount of
principal to be paid at maturity, a contract or stated interest rate (e.g., 5%
-- meaning that the bond pays interest each year equal to 5% of the face
amount), and a term (e.g., 10 years -- meaning the bond matures 10 years from
the designated issue date). In other words, a $1,000, 5%, 10-year bond would
pay $50 per year for 10 years (as interest), and then pay $1,000 at the stated
maturity date.
How
much would one pay for a 5%, 10-year bond: Exactly $1,000, more than $1,000, or
less than $1,000? The answer to this question depends on many factors,
including the credit-worthiness of the issuer, the remaining time to maturity,
and the overall market conditions. If the "going rate" of interest
for other bonds was 8%, one would likely avoid this 5% bond (or, only buy it if
it were issued at a deep discount). On the other hand, the 5% rate might look
pretty good if the "going rate" was 3% for other similar bonds (in
which case one might actually pay a premium to get the bond). So, bonds might
have an issue price that is at face value (also known as par), or above (at a
premium) or below (at a discount) face. The price of a bond is typically stated
as percentage of face; for example 103 would mean 103% of face, or $1,030. The
specific calculations that are used to determine the price one would pay for a
particular bond are revealed in a subsequent chapter.
An
Investment in Bonds account (at the purchase price plus brokerage fees and
other incidental acquisition costs) is established at the time of purchase.
Premiums and discounts on bond investments are not recorded in separate accounts:
The
above entry reflects a bond purchase as described, while the following entry
reflects the correct accounting for the receipt of the first interest payment
after 6 months.
The
entry that is recorded on June 30 would be repeated with each subsequent
interest payment, continuing through the final interest payment on December 31,
20X5. In addition, at maturity, when the bond principal is repaid, the investor
would also make this final accounting entry:
When
bonds are purchased at a premium, the investor pays
more than the face value up front. However, the bond's maturity value is
unchanged; thus, the amount due at maturity is less than the initial issue
price! This may seem unfair, but consider that the investor is likely
generating higher annual interest receipts than on other available bonds.
Assume the same facts as for the preceding bond illustration, but this time
imagine that the market rate of interest was something less than 5%. Now, the
5% bonds would be very attractive, and entice investors to pay a premium:
The
above entry assumes the investor paid 106% of par ($5,000 X 106% = $5,300).
However, remember that only $5,000 will be repaid at maturity. Thus, the
investor will be "out" $300 over the life of the bond. Thus, accrual
accounting dictates that this $300 "cost" be amortized
("recognized over the life of the bond") as a reduction of the
interest income:
The
preceding entry can be confusing and bears additional explanation. Even though
$125 was received, only $75 is being recorded as interest income. The other $50
is treated as a return of the initial investment; it corresponds to the premium
amortization ($300 premium allocated evenly over the life of the bond: $300 X
(6 months/36 months)). The premium amortization is credited against the
Investment in Bonds account. This process of premium amortization would be
repeated with each interest payment. Therefore, after three years, the
Investment in Bonds account would be reduced to $5,000 ($5,300 - ($50
amortization X 6 semiannual interest recordings)).
This
method of tracking amortized cost is called the straight-line method. There is another conceptually
superior approach to amortization, called the effective-interest method, which
will be revealed in later chapters. However, it is a bit more complex and the
straight-line method presented here is acceptable so long as its results are
not materially different than would result under the effective-interest method.
In
addition, at maturity, when the bond principal is repaid, the investor would
make this final accounting entry:
In
an attempt to make sense of the preceding, perhaps it is helpful to reflect on
just the "cash out" and the "cash in." How much cash did
the investor pay out? It was $5,300; the amount of the initial investment. How
much cash did the investor get back? It was $5,750; $125 every 6 months for 3
years and $5,000 at maturity. What is the difference? It is $450 ($5,750 -
$5,300). This is equal to the income recognized via the journal entries ($75
every 6 months, for 3 years). At its very essence, accounting measures the
change in money as income. Bond accounting is no exception, although it is
sometimes illusive to see. The following "amortization" table reveals
certain facts about the bond investment accounting, and is worth studying
closely. Be sure to "tie" the amounts in the table to the illustrated
journal entries.
Sometimes,
complex transactions are easier to understand when one simply thinks about the
balance sheet impact. For example, on December 31 20X4, Cash is increased $125,
but the Investment in Bonds account is decreased by $50 (dropping from $5,150
to $5,100). Thus, total assets increased by a net of $75. The balance sheet
remains in balance because the corresponding $75 of interest income causes a
corresponding increase in retained earnings.
The
discount scenario is very similar to the premium, but "in reverse."
When bonds are purchased at a discount, the investor pays less than the face value up front.
However, the bond's maturity value is unchanged; thus, the amount due at
maturity is more than the initial issue price! This may seem like a bargain,
but consider that the investor is likely getting lower annual interest receipts
than is available on other bonds.
Assume
the same facts as for the previous bond illustration, except imagine that the
market rate of interest was something more than 5%. Now, the 5% bonds would not
be very attractive, and investors would only be willing to buy them at a
discount:
The
above entry assumes the investor paid 97% of par ($5,000 X 97% = $4,850).
However, remember that a full $5,000 will be repaid at maturity. Thus, the
investor will get an additional $150 over the life of the bond. Accrual
accounting dictates that this $150 "benefit" be recognized over the
life of the bond as an increase in interest income:
The
preceding entry would be repeated at each interest payment date. Again, further
explanation may prove helpful. In addition to the $125 received, another $25 of
interest income is recorded. The other $25 is added to the Investment in Bonds
account, as it corresponds to the discount amortization ($150 discount
allocated evenly over the life of the bond: $150 X (6 months/36 months)=$25).
This
process of discount amortization would be repeated with each interest payment.
Therefore, after three years, the Investment in Bonds account would be
increased to $5,000 ($4,850 + ($25 amortization X 6 semiannual interest
recordings)). This example again uses the straight-line method of amortization
since the amount of interest is the same each period. The alternative
effective-interest method demonstrated later in the book would be required if
the results would be materially different.
When
the bond principal is repaid at maturity, the investor would also make this
final entry:
Consider
the "cash out" and the "cash in." How much cash did the
investor pay out? It was $4,850; the amount of the initial investment. How much
cash did the investor get back? It is the same as it was in the premium
illustration: $5,750 ($125 every 6 months for 3 years and $5,000 at maturity).
What is the difference? It is $900 ($5,750 - $4,850). This is equal to the
income recognized ($150 every 6 months, for 3 years). Be sure to "tie"
the amounts in the following amortization table to the related entries.
What
is the balance sheet impact on June 30, 20X5? Cash increased by $125, and the
Investment in Bonds account increased $25. Thus, total assets increased by
$150. The balance sheet remains in balance because the corresponding $150 of
interest income causes a corresponding increase in retained earnings.
Amortizing Bond Premium with the Effective Interest Rate Method
When a bond is sold at a premium, the amount of the bond premium
must be amortized to interest expense over the life of the bond. In other
words, the credit balance in the account Premium on Bonds Payable must be moved
to the account Interest Expense thereby reducing interest expense in each of
the accounting periods that the bond is outstanding.
The preferred method for amortizing the bond premium is the effective
interest rate method or the effective interest method. Under the
effective interest rate method the amount of interest expense in a given year
will correlate with the amount of the bond’s book value. This means that when a
bond’s book value decreases, the amount of interest expense will decrease. In
short, the effective interest rate method is more logical than the
straight-line method of amortizing bond premium.
Before we demonstrate the effective interest rate method for
amortizing the bond premium pertaining to a 5-year 9% $100,000 bond issued in
an 8% market for $104,100 on January 1, 2012, let's outline a few concepts:
- The bond premium of $4,100
must be amortized to Interest Expense over the life of the bond. This
amortization will cause the bond’s book value to decrease from $104,100 on
January 1, 2012 to $100,000 just prior to the bond maturing on December
31, 2016.
- The corporation must make an
interest payment of $4,500 ($100,000 x 9% x 6/12) on each June 30 and
December 31. This means that the Cash account will be credited for $4,500
on each interest payment date.
- The effective interest rate
method uses the market interest rate at the time that the bond was
issued. In our example, the market interest rate on January 1, 2012 was 4%
per semiannual period for 10 semiannual periods.
- The effective interest rate
is multiplied times the bond’s book value at the start of the accounting
period to arrive at each period’s interest expense.
- The difference between Item
2 and Item 4 is the amount of amortization.
The following table illustrates the effective interest rate method
of amortizing the $4,100 premium on a corporation’s bonds payable:
|
A
|
B
|
C
|
D
|
E
|
F
|
G
|
|
Date
|
Interest Payment Stated
4.5% x Face |
Interest Expense
Mkt 4% x Previous BV in G |
Amortization
Of Bond Premium C minus B |
Credit Balance
In Bond Premium Account |
Credit Balance
In Bonds Payable Account |
Book Value of the
Bonds F plus E
|
|
Credit Cash
|
Debit Interest
Expense
|
Debit
Bond Premium |
||||
|
Jan 1, 2012
|
$ 4,100
|
$ 100,000
|
$ 104,100
|
|||
|
Jun 30, 2012
|
$ 4,500
|
$ 4,164
|
$ (336)
|
$ 3,764
|
$ 100,000
|
$ 103,764
|
|
Dec 31, 2012
|
$ 4,500
|
$ 4,151
|
$ (349)
|
$ 3,415
|
$ 100,000
|
$ 103,415
|
|
Jun 30, 2013
|
$ 4,500
|
$ 4,137
|
$ (363)
|
$ 3,052
|
$ 100,000
|
$ 103,052
|
|
Dec 31, 2013
|
$ 4,500
|
$ 4,122
|
$ (378)
|
$ 2,674
|
$ 100,000
|
$ 102,674
|
|
Jun 30, 2014
|
$ 4,500
|
$ 4,107
|
$ (393)
|
$ 2,281
|
$ 100,000
|
$ 102,281
|
|
Dec 31, 2014
|
$ 4,500
|
$ 4,091
|
$ (409)
|
$ 1,872
|
$ 100,000
|
$ 101,872
|
|
Jun 30, 2015
|
$ 4,500
|
$ 4,075
|
$ (425)
|
$ 1,447
|
$ 100,000
|
$ 101,447
|
|
Dec 31, 2015
|
$ 4,500
|
$ 4,058
|
$ (442)
|
$ 1,005
|
$ 100,000
|
$ 101,005
|
|
Jun 30, 2016
|
$ 4,500
|
$ 4,040
|
$ (460)
|
$ 545
|
$ 100,000
|
$ 100,545
|
|
Dec 31, 2016
|
$ 4,500
|
$ 3,955
|
$ (545)
|
$
0
|
$ 100,000
|
$ 100,000
|
|
Totals
|
$ 45,000
|
$ 40,900
|
$ ( 4,100)
|
|||
Please make note of the following points:
If the company issues only annual financial statements and
its accounting year ends on December 31, the amortization of the bond premium
can be recorded at the interest payment dates by using the amounts from the
schedule above. In our example there was no accrued interest at the issue date
of the bonds and there is no accrued interest at the end of each accounting year
because the bonds pay interest on June 30 and December 31. The entries for
2012, including the entry to record the bond issuance, are:
|
Jan 1, 2012
|
Cash
|
104,100
|
|
Bonds Payable
|
100,000
|
|
Premium on Bonds
Payable
|
4,100
|
|
Jun 30, 2012
|
Interest Expense
|
4,164
|
|
Premium on Bonds
Payable
|
336
|
|
Cash
|
4,500
|
|
Dec 31, 2012
|
Interest Expense
|
4,151
|
|
Premium on Bonds
Payable
|
349
|
|
Cash
|
4,500
|
The journal entries for the year 2013 are:
|
Jun 30, 2013
|
Interest Expense
|
4,137
|
|
Premium on Bonds
Payable
|
363
|
|
Cash
|
4,500
|
|
Dec 31, 2013
|
Interest Expense
|
4,122
|
|
Premium on Bonds
Payable
|
378
|
|
Cash
|
4,500
|
The journal entries for 2014, 2015, and 2016 will also be taken
from the schedule above.
Comparison of Amortization Methods
Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.
Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.
|
Effective
Interest Rate Method
|
Straight-Line
Method
|
|||
|
Year
|
Interest
Expense |
Book Value at
Beg. of Year |
Interest
Expense |
Book Value at
Beg. of Year |
|
2012
|
$ 8,315
|
$ 104,100
|
$ 8,180
|
$ 104,100
|
|
2013
|
$ 8,259
|
$ 103,415
|
$ 8,180
|
$ 103,280
|
|
2014
|
$ 8,198
|
$ 102,674
|
$ 8,180
|
$ 102,460
|
|
2015
|
$ 8,133
|
$ 101,872
|
$ 8,180
|
$ 101,640
|
|
2016
|
$ 7,995
|
$ 101,005
|
$ 8,180
|
$ 100,820
|
|
Totals
|
$ 40,900
|
$ 40,900
|
||
Notice that under both methods of amortization, the book value at
the time the bonds were issued ($104,100) moves toward the bond's maturity
value of $100,000. The reason is that the bond premium of $4,100 is being
amortized to interest expense over the life of the bond.
Also notice that under both methods the corporation's total
interest expense over the life of the bond will be $40,900 ($45,000 of interest
payments minus the $4,100 of premium received from the purchasers of the bond
when it was issued.)
Amortizing Bond Discount with the Effective Interest Rate Method
When a bond is sold at a discount, the amount of the bond discount
must be amortized to interest expense over the life of the bond. Since the
debit amount in the account Discount on Bonds Payable will be moved to the
account Interest Expense, the amortization will cause each period’s interest
expense to be greater than the amount of interest paid during each of the years
that the bond is outstanding.
The preferred method for amortizing the bond discount is the effective
interest rate method or the effective interest method. Under the
effective interest rate method the amount of interest expense in a given
accounting period will correlate with the amount of a bond’s book value at the
beginning of the accounting period. This means that as a bond’s book value
increases, the amount of interest expense will increase.
Before we demonstrate the effective interest rate method for a
5-year 9% $100,000 bond issued in a 10% market for $96,149, let's highlight a
few points:
- The bond discount of $3,851
must be amortized to Interest Expense over the life of the bond. The
amortization will cause the bond’s book value to increase from $96,149 on
January 1, 2012 to $100,000 just prior to the bond maturing on December
31, 2016.
- The corporation must make an
interest payment of $4,500 ($100,000 x 9% x 6/12) on each June 30 and
December 31 that the bonds are outstanding. The Cash account will be
credited for $4,500 on each of these dates.
- The effective interest rate
is the market interest rate on the date that the bonds were issued.
In our example the market interest rate on January 1, 2012 was 5% per
semiannual period for 10 semiannual periods.
- The effective interest rate
is multiplied times the bond’s book value at the start of the accounting
period to arrive at each period’s interest expense.
- The difference between Item
2 and Item 4 is the amount of amortization.
The following table illustrates the effective interest rate method
of amortizing the $3,851 discount on bonds payable:
|
A
|
B
|
C
|
D
|
E
|
F
|
G
|
|
Date
|
Interest Payment Stated
4.5% x Face |
Interest Expense
Mkt 5% x Previous BV in G |
Amortization of
Bond Discount
C minus B |
Debit Balance In
the Account
Bond Discount |
Credit Balance In
the Account
Bonds Payable |
Book Value of the
Bonds
F minus E |
|
Credit
Cash |
Debit
Interest Expense |
Credit
Bond Discount |
||||
|
Jan 1, 2012
|
$ 3,851
|
$ 100,000
|
$ 96,149
|
|||
|
Jun 30, 2012
|
$ 4,500
|
$ 4,807
|
$ 307
|
$ 3,544
|
$ 100,000
|
$ 96,456
|
|
Dec 31, 2012
|
$ 4,500
|
$ 4,822
|
$ 322
|
$ 3,222
|
$ 100,000
|
$ 96,778
|
|
Jun 30, 2013
|
$ 4,500
|
$ 4,839
|
$ 339
|
$ 2,883
|
$ 100,000
|
$ 97,117
|
|
Dec 31, 2013
|
$ 4,500
|
$ 4,856
|
$ 356
|
$ 2,527
|
$ 100,000
|
$ 97,473
|
|
Jun 30, 2014
|
$ 4,500
|
$ 4,874
|
$ 374
|
$ 2,153
|
$ 100,000
|
$ 97,847
|
|
Dec 31, 2014
|
$ 4,500
|
$ 4,892
|
$ 392
|
$ 1,761
|
$ 100,000
|
$ 98,239
|
|
Jun 30, 2015
|
$ 4,500
|
$ 4,912
|
$ 412
|
$ 1,349
|
$ 100,000
|
$ 98,651
|
|
Dec 31, 2015
|
$ 4,500
|
$ 4,933
|
$ 433
|
$ 916
|
$ 100,000
|
$ 99,084
|
|
Jun 30, 2016
|
$ 4,500
|
$ 4,954
|
$ 454
|
$ 462
|
$ 100,000
|
$ 99,538
|
|
Dec 31, 2016
|
$ 4,500
|
$ 4,962
|
$ 462
|
$
0
|
$ 100,000
|
$ 100,000
|
|
Totals
|
$ 45,000
|
$ 48,851
|
$ 3,851
|
|||
Let’s make a few points about the above table:
If the company issues only annual financial statements and
its accounting year ends on December 31, the amortization of the bond discount
can be recorded on the interest payment dates by using the amounts from the
schedule above. In our example, there is no accrued interest at the issue date
of the bonds and at the end of each accounting year because the bonds pay
interest on June 30 and December 31. The entries for 2012, including the entry
to record the bond issuance, are shown next.
|
Jan 1, 2012
|
Cash
|
96,149
|
|
Discount on Bonds
Payable
|
3,851
|
|
Bonds Payable
|
100,000
|
|
Jun 30, 2012
|
Interest Expense
|
4,807
|
|
Discount on Bonds
Payable
|
307
|
|
Cash
|
4,500
|
|
Dec 31, 2012
|
Interest Expense
|
4,822
|
|
Discount on Bonds
Payable
|
322
|
|
Cash
|
4,500
|
The journal entries for the year 2013 are:
|
Jun 30, 2013
|
Interest Expense
|
4,839
|
|
Discount on Bonds Payable
|
339
|
|
Cash
|
4,500
|
|
Dec 31, 2013
|
Interest Expense
|
4,856
|
|
Discount on Bonds
Payable
|
356
|
|
Cash
|
4,500
|
The journal entries for the years 2014 through 2016 will also be
taken from the schedule shown above.
Comparison of Amortization Methods
Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
|
Effective
Interest Rate Method
|
Straight-Line
Method
|
|||
|
Year
|
Interest
Expense |
Book Value at
Beg. of Year |
Interest
Expense |
Book Value at
Beg. of Year |
|
2012
|
$ 9,629
|
$ 96,149
|
$ 9,770
|
$ 96,149
|
|
2013
|
$ 9,695
|
$ 96,778
|
$ 9,770
|
$ 96,919
|
|
2014
|
$ 9,766
|
$ 97,473
|
$ 9,770
|
$ 97,689
|
|
2015
|
$ 9,845
|
$ 98,239
|
$ 9,770
|
$ 98,459
|
|
2016
|
$ 9,916
|
$ 99,084
|
$ 9,771
|
$ 99,229
|
|
Totals
|
$ 48,851
|
$ 48,851
|
||
Notice that under both methods of amortization, the book value at
the time the bonds were issued ($96,149) moves toward the bond’s maturity value
of $100,000. The reason is that the bond discount of $3,851 is being reduced to
$0 as the bond discount is amortized to interest expense.
Also notice that under both methods the total interest expense
over the life of the bonds is $48,851 ($45,000 of interest payments plus the
$3,851 of bond discount.)
Summary of the Effect of Market Interest Rates on a Bond’s Issue
Price
The following table summarizes the effect of the change in the market interest rate on an existing $100,000 bond with a stated interest rate of 9% and maturing in 5 years.
The following table summarizes the effect of the change in the market interest rate on an existing $100,000 bond with a stated interest rate of 9% and maturing in 5 years.
|
Bond’s Stated
Interest
Rate per Year |
Market Interest
Rate per Year |
Issue Price of Bond
(Present Value) |
Bond Issued At
|
|
9%
|
9%
|
$100,000
|
Par
|
|
9%
|
8%
|
$104,100
|
Premium
|
|
9%
|
10%
|
$ 96,149
|
Discount
|
Additional Bond Terminology
Bonds are a form of long-term debt and might be referred to as a
debt security.
Bonds allow corporations to use financial leverage or to trade
on equity. The reason is that a corporation issuing bonds can control
larger amounts of assets without increasing its common stock.
Bonds that mature on a single maturity date are known as term
bonds. Bonds that mature over a series of dates are serial bonds.
Bonds that have specific assets pledged as collateral are secured
bonds. An example of a secured bond would be a mortgage bond that
has a lien on real estate.
Bonds that do not have specific collateral and instead rely on the
corporation’s general financial position are referred to as unsecured bonds
or debentures.
Convertible bonds allow the bondholder to exchange the
bond for a specified number of shares of common stock. Most bonds are not
convertible bonds.
Some bonds require the issuing corporation to deposit money into
an account that is restricted for the payment of the bonds’ maturity amount.
The restricted account is Bond Sinking
Fund and it is reported in the long-term investment section of the
balance sheet.
Callable bonds are bonds that give the issuing corporation the right to
repurchase its bonds by paying the bondholders the bonds’ face amount plus an
additional amount known as the call premium. The call premium might be
one year of additional interest. A bond’s call price and other
conditions can be found in a bond’s contract known as the indenture.
Many years ago corporate bonds could be unregistered. Such bonds
were known as bearer bonds and the bonds had coupons attached that the
bearer would “clip” and deposit at the bearer’s bank. Today, corporations do
not issue bearer bonds. Instead, they issue registered bonds.
There are various fees that a corporation must pay when issuing
bonds. These fees include payments to attorneys, accounting firms, and
securities consultants. These costs are referred to as issue costs.
Issue costs are likely to be recorded in the account Bond Issue Costs. This account
appears on the balance sheet under the heading of Other Assets or Deferred
Charges. Over the life of the bonds the balance in the long term asset account
Bond Issue Costs will be amortized to expense.
When bond interest rates are discussed, the term basis point
is often used. A basis point is 1/100th of one percentage point. For example,
if a market interest rate increases from 6.25% to 6.50%, the rate is said to
have increased by 25 basis points
