CHAPTER 10 Addendum
Redemption of Bonds p. 405
Retired Early at a Gain
A firm may want to retire bonds before their due date for several reasons. A firm may simply have
excess cash and determine that the best use of those funds is to repay outstanding bond obligations.
Bonds also may be retired early because of changing interest rate conditions. If interest rates in the
economy decline, firms may find it advantageous to retire bonds that have been issued at higher rates.
Of course, what is advantageous to the issuer is not necessarily so for the investor. Early retirement of
callable bonds is always a possibility that must be anticipated. Large institutional investors expect
such a development and merely reinvest the money elsewhere. Many individual investors are more
seriously inconvenienced when a bond issue is called.
Bond terms generally specify that if bonds are retired before their due date, they are not retired at the
face value amount, but at a call price or redemption price indicated on the bond certificate. Also, the
amount of unamortized premium or discount on the bonds must be considered when bonds are retired
early. The retirement results in a gain or loss on redemption that must be calculated as follows:
Gain = Carrying Value – Redemption Price
Loss = Redemption Price – Carrying Value
In other words, the issuing firm must calculate the carrying value of the bonds at the time of
redemption and compare it with the total redemption price. If the carrying value is higher than the
redemption price, the issuing firm must record a gain. If the carrying value is lower than the
redemption price, the issuing firm must record a loss.
We will use the Premium Firm example to illustrate the calculation of gain or loss. Assume that on
December 31, 2008, Premium Firm wants to retire its bonds due in 2011. Assume, as in the previous
section, that the bonds were issued at a premium of $692 at the beginning of 2008. Premium Firm has
used the straight line method of amortization and has recorded the interest and amortization entry for
the year. (See page 404). This has resulted in a balance of $519 in the Premium on Bonds Payable
account at December 31, 2008. Also assume that Premium Firm’s bond certificates indicate the bonds
may be retired early at a call price of 102 (meaning 102% of face value). Thus, the redemption price is
102% of $10,000 or $10,200.
Premium Firm’s retirement of bonds would result in a gain. The gain can be calculated using two
steps:
1) Calculate the carrying value of the bonds at the date they are retired. The carrying value of
Premium Firm’s bonds at that date is calculated as follows:
Carrying Value = Face Value + Unamortized Premium
= $10,000 + $519
= $10,519
2) Calculate the gain:
Gain = Carrying Value – Redemption Price
= $10,519 – ($10,000 X 1.02)
= $10,519 - $10,200
= $319
When bonds are retired, the balance of the Bonds Payable account and the remaining balance of the
Premium on Bonds Payable account must be eliminated from the balance sheet.
Retired Early at a Loss
To illustrate retirement of bonds at a loss, assume that Premium Firm retires bonds at December 31,
2008, as in the previous section. However, assume that the call price for the bonds is 107 (or 107% of
face value). Again, the calculations can be performed in two steps:
1) Calculate the carrying value:
Carrying Value = Face Value + Unamortized Premium
= $10,000 + 519
= $10,519
2) Compare the carrying value with the redemption price to calculate the amount of the loss:
Loss = Redemption Price – Carrying Value
= ($10,000 X 1.07) - $10,519
= $10,700 - $10,519
= $181
In this case, a loss of $181 has resulted from the retirement of Premium Firm bonds. A loss means that
the company paid more to retire the bonds than the amount at which the bonds were recorded on the
balance sheet.
Financial Statement Presentation of Gain or Loss
The accounts Gain on Bond Redemption and Loss on Bond Redemption are income statement
accounts. A gain on bond redemption increases Premium Firm’s income; a loss decreases its income.
While gains and losses should be treated as part of the company’s operating income, some statement
users may consider them as “one-time” events and choose to exclude them when predicting a
company’s future income. For that reason, it would be very helpful if companies would present their
gains and losses separately on the income statement so that readers could determine whether such
amounts will affect future periods.