Bonds and Long-Term Notes
BONDS
Long-term debt is comprised of those obligations that will become due in more than one year or
the operating cycle whichever is longer. The two types of long-term debt discussed in this
chapter are bonds and long-term notes. Long-term debt typically has covenants or restrictions
imposed on the borrower to protect the lender.
Bonds
Bonds are long-term obligations issued by publicly traded companies that segment the obligation
into multiple instruments so that it can be sold to a large number of investors. The bonds are
normally denominated in $1,000 increments so that if the company issues $10 million in bonds it
is actually issuing 10,000, $1,000 bonds. The contract is called a bond indenture, which is the
promise to pay a sum certain (Face Amount), plus periodic interest (Stated Interest) based on
the face amount of the bond.
Valuation of Bonds
The time lag between the authorization and issuance of bonds is rather long. The bonds are
issued at a stated, coupon or nominal rate of interest which is set long before the bonds are
actually issued. During this time lag market interest rates may have increased or decreased
relative to the stated rate. The interest paid on a bond is the stated rate based on the face amount
(par value, principal amount, or maturity value). At the date of issue the bonds will be sold to
the investment community based on market interest rates. The investment community values the
bonds at the present value of their future cash flow, which includes the principal payment at the
maturity date and the periodic interest payments. Both these cash flows are discounted at the
market rate of interest on the date of issue. If the stated rate and the market rate are different the
bonds will be sold at a premium (the market rate is less than the stated rate) or at a discount (the
market rate is greater than the stated rate).
Example: Bonds Issued at Par
Spencer Company issued 100, $1,000, 10-year bonds that pay interest semiannually on April 1
and October 1 at 10% per year. The bonds are issued at par on April 1, 2006.
The following is the analysis of the bond issue price:
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Bonds and Long-Term Notes
Issue Price of the Bonds
$100,000
0.37689
Face value
PV of 1, n=20, i=5%
PV of face value
Face value
Stated interest rate
Annual interest
Payments per year
Semi-annual interest payments
PVOA, n=20, i=5%
PV of annuity
Issue price of the bonds
$37,689
100,000
10%
10,000
2
5,000
12.46221
62,311
$100,000
On April 1, 2006 the bonds will be issued at par. Because the stated interest rate and the market
interest rate are identical the bonds will be sold at the face amount.
Date
4/1/06
Account
Debit
Credit
Cash
$100,000
Bonds payable
$100,000
To record the issuance of 100, $1,000, 10-year bonds at par with an annual
interest rate of 10%
On October 1, 2006 the first semiannual interest payment will be made to the bond holders. The
journal entry to record this payment is as follows:
Date
10/1/06
Account
Debit
Credit
Bond interest expense
$5,000
Cash
$5,000
To record the payment of interest on the bonds payable at October 1, 2006
Analysis of interest expense:
Face value
Stated interest rate
Annual interest
Payments per year
Semi-annual interest payments
$100,000
10%
10,000
2
$5,000
If we assume the Spencer Company is a calendar year corporation then the company will need to
record a year-end accrual for the interest payable on the bonds in order to prepare the December
31, 2006 financial statements. The journal entry for the accrual of the short-period interest is as
follows:
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Bonds and Long-Term Notes
Date
Account
Debit
12/31/06 Bond interest expense
$2,500
Bond interest payable
To record bond interest payable on December 31, 2006
Analysis of interest expense:
Face value
Stated interest rate
Annual interest
Months left in 2006
Bond interest payable
Credit
$2,500
$100,000
10%
10,000
3/12
$2,500
Amortization of Premium or Discount on Bonds Payable
If the market rate of interest is different than the stated rate on the bonds, they will be sold at a
premium or discount. There are two methods of amortizing the premium or discount: the
straight-line method and the effective interest method. GAAP requires the use of the effective
interest method. All of the examples in this lesson will focus on the effective interest method.
The purpose of the effective interest method is to reflect the effective interest on the bonds in
each accounting period with corresponds to the market rate of interest on the date of issue. The
following are the formulas for amortization of a discount and amortization of a premium.
•
Amortization of Discount
INTEREST EXPENSE
Period
Carrying value
Effective
of bonds at
Less
X
Interest
beginning of
Rate
period
•
INTEREST PAID
Period
Stated
X
Interest
Face Amount of
Rate
Bonds
AMORTIZATION
=
Amortization of
Discount
Amortization of a Premium
INTEREST PAID
X
Face Amount
of Bonds
INTEREST EXPENSE
Carrying value of
Period
Period
Stated Less
bonds at
=
X
Effective
Interest
beginning of
Interest Rate
Rate
period
AMORTIZATION
Amortization of
Premium
Example: Bonds Issued at a Discount
Spencer Company issued 100, $1,000, 10-year bonds that pay interest semiannually on April 1
and October 1 at 10% per year. The market rate of interest on the April 1, 2006, the date the
bonds were sold was 12%. The issue price of the bonds would be calculated as follows:
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Bonds and Long-Term Notes
Issue Price of the Bonds
$100,000
0.31180
Face value
PV of 1, n=20, i=6%
PV of face value
Face value
Stated interest rate
Annual interest
Payments per year
Semi-annual interest payments
PVOA, n=20, i=6%
PV of annuity
Issue price of the bonds
$31,180
100,000
10%
10,000
2
5,000
11.46992
57,350
$88,530
The journal entry to record the issuance of the bonds would be as follows:
Date
4/1/06
Account
Debit
Credit
Cash
$88,530
Discount on bonds payable
11,470
Bonds payable
$100,000
To record the issuance of 100, $1,000, 10-year bonds at 10% interest per
annum with an effective yield of 12%
At this point it is helpful to prepare a schedule of amortization of bond discount. The following
schedule reflects the payment of the semiannual interest payments and the amortization of the
discount for the life of the bond issue. Please note that the interest expense is 6% of the carrying
amount of the bond.
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Bonds and Long-Term Notes
Date
4/1/06
10/1/06
4/1/07
10/1/07
4/1/08
10/1/08
4/1/09
10/1/09
4/1/10
10/1/10
4/1/11
10/1/11
4/1/12
10/1/12
4/1/13
10/1/13
4/1/14
10/1/14
4/1/15
10/1/15
4/1/16
Schedule of Amortization of Bond Discount
Interest
Interest
Discount
Carrying
Payment
Expense Amortization Amount
$88,530
$5,000
$5,312
$312
88,842
5,000
5,331
331
89,173
5,000
5,350
350
89,523
5,000
5,371
371
89,894
5,000
5,394
394
90,288
5,000
5,417
417
90,705
5,000
5,442
442
91,147
5,000
5,469
469
91,616
5,000
5,497
497
92,113
5,000
5,527
527
92,640
5,000
5,558
558
93,198
5,000
5,592
592
93,790
5,000
5,627
627
94,417
5,000
5,665
665
95,082
5,000
5,705
705
95,787
5,000
5,747
747
96,534
5,000
5,792
792
97,326
5,000
5,840
840
98,166
5,000
5,890
890
99,056
5,000
5,943
944
100,000
$100,000
$111,469
$11,470
To record the first interest payment we need to calculate the market interest on the carrying
amount. This is the interest expense. The difference between the actual interest payment and the
interest expense is amortization of the discount. The discount is added to the carrying value to
derive the new carrying value. On the maturity date the carrying value will be the face amount
of $100,000. The following journal entry is prepared to record the first interest payment on
October 1, 2006.
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Bonds and Long-Term Notes
Date
10/1/06
Account
Debit
Credit
Bond interest expense
$5,312
Discount on bonds payable
$312
Cash
5,000
To record the payment, interest expense and amortization of discount on
bonds payable for October 1, 2006
Analysis of amortization of discount:
Carrying value of bonds
Effective interest rate
Interest expense
Interest payment
Amortization of discount
$88,530
6%
5,312
5,000
$312
If we again assume the Spencer Company is a calendar year corporation then the company will
need to do a year-end accrual of the interest expense and interest payable on the bonds in order to
prepare the December 31, 2006 financial statements. The journal entry for the accrual of the
short-period interest is as follows:
Date
Account
12/31/06 Bond interest expense
Discount on bonds payable
Interest payable
Debit
$2,665
Credit
$165
2,500
To record interest expense, amortization of discount and interest payable
on December 31, 2006
Analysis of amortization of discount:
Carrying value of bonds
Effective interest rate
Interest expense
Months left in 2002
Interest expense
Interest payment
Months left in 2002
Interest payable
Amortization of discount
$88,842
6%
5,331
3/6
$2,665
5,000
3/6
2,500
$165
Example: Bonds Issued at a Premium
Spencer Company issued 500, $1,000, 5-year bonds that pay interest annually on September 1 at
10% per year. The market rate of interest on the September 1, 2006, the date the bonds were
sold is 8%. The issue price of the bonds would be calculated as follows:
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Bonds and Long-Term Notes
Face value
PV of 1, n=5, i=8%
PV of face value
Face value
Stated interest rate
Annual interest
PVOA, n=5, i=8%
PV of annuity
Issue price of the bonds
Issue Price of the Bonds
$500,000
0.68058
$340,290
500,000
10%
50,000
3.99271
199,636
$539,926
The journal entry to record the sale of the bonds would be as follows:
Date
9/1/06
Account
Debit
539,926
Credit
Cash
Premium on bonds payable
39,926
Bonds payable
500,000
To record the issuance of 500, $1,000, 5-year bonds at 10% interest per
annum with an effective yield of 8%
The following is a schedule of amortization of bond premium.
Schedule of Amortization of Bond Premium
Date
9/1/06
9/1/07
9/1/08
9/1/09
9/1/10
9/1/11
Interest
Payment
$50,000
50,000
50,000
50,000
50,000
$250,000
Interest
Expense
$43,194
42,650
42,062
41,427
40,741
$210,074
Premium
Amortization
$6,806
7,350
7,938
8,573
9,259
$39,926
Carrying
Amount
$539,926
533,120
525,770
517,832
509,259
500,000
Using the above schedule, the journal entry to record the accrual of interest expense,
amortization of premium and interest payable on December 31, 2006 would be as follows:
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Bonds and Long-Term Notes
Date
Account
12/31/06 Bond interest expense
Premium on bonds payable
Interest payable
Debit
$14,398
2,269
Credit
$16,667
To record bond interest expense, amortization of premium and accrued
bond interest payable at December 31, 2006
Analysis of amortization of premium:
Bond interest on September 1, 2007
Number of months in 2006
Bond interest expense for 2006
Interest payment on September 1, 2007
Number of months in 2006
Bond interest payable at Dember 31, 2006
Amortization of premium for 2006
$43,194
4/12
$14,398
50,000
4/12
16,667
$2,269
The journal entry to record the payment of interest, interest expense and amortization of the
premium on September 1, 2003 would be as follows:
Date
9/1/07
Account
Debit
Credit
Bond interest expense
$28,796
Premium on bonds payable
4,537
Bond interest payable
16,667
Cash
$50,000
To record interest expense, interest payment and amortization of premium
on bonds payable at September 1, 2007
Analysis of amortization of premium:
Bond interest on September 1, 2003
Accrued in 2002
Bond interest expense for 2003
Interest payment on September 1, 2003
Accrued in 2002
Portion allocated to 2003
Amortization of premium for 2003
$43,194
14,398
$28,796
50,000
16,667
33,333
$4,537
Bonds Issued between Interest Dates
The stated interest is paid to the bond holder on the interest payment date. If the bonds are sold
at some date other than the interest payment date the amount of accrued interest up to the date of
the transaction is accrued and paid to the seller. The buyer is reimbursing the seller up front for
the interest that will be paid to the buyer on the next interest payment date.
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Bonds and Long-Term Notes
Example: Spencer Company issued 100, $1,000, 10% bonds on April 1, 2006. The bonds were
dated January 1, 2006 and mature on January 1, 2007, with interest payable on July 1, and
January 1. The bonds were issued to yield 8% per annum plus accrued interest. The calculation
of the issue price is as follows:
Issue Price of the Bonds
$100,000
0.67556
Face value
PV of 1, n=10, i=4%
PV of face value
Face value
Stated interest rate
Annual interest
Payments per year
Semi-annual interest payments
PVOA, n=10, i=4%
PV of annuity
Issue price of the bonds
$67,556
100,000
10%
10,000
2
5,000
8.11090
40,555
$108,111
The journal entry to record the sale of the bonds would be as follows:
Date
4/1/06
Account
Debit
Credit
Cash
$110,611
Premium on bonds payable
$8,111
Bonds payable
100,000
Interest expense
2,500
To record the issuance of 100, $1,000, 10% bonds including accrued
interest on April 1, 2006
Analysis of cash received:
Issue price of bonds
Semi-annual interest payment, July 1
Months from 1/1 to 4/1
Accrued interest
Cash received
$108,111
$5,000
3/6
2,500
$110,611
The schedule of amortization of bonds premium is as follows:
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Bonds and Long-Term Notes
Date
1/1/06
7/1/06
1/1/07
7/1/07
1/1/08
7/1/08
1/1/09
7/1/09
1/1/10
7/1/10
1/1/11
Schedule of Amortization of Bond Premium
Interest
Interest
Premium
Carrying
Payment
Expense Amortization Amount
$108,111
$5,000
$4,324
$676
107,435
5,000
4,297
703
106,732
5,000
4,269
731
106,001
5,000
4,240
760
105,241
5,000
4,210
790
104,451
5,000
4,178
822
103,629
5,000
4,145
855
102,774
5,000
4,111
889
101,885
5,000
4,075
925
100,960
5,000
4,040
960
100,000
$50,000
$41,889
$8,111
The following journal entry records the payment of interest and amortization of premium on July
1, 2006.
Date
7/1/06
Account
Debit
$4,324
676
Credit
Interest expense
Premium on bonds payable
Cash
$5,000
To record the interest payment, interest expense and the amortization of the
premium on the July 1, 2006 payment.
The following journal entry records interest expense, amortization of premium and accrual of
interest payable at December 31, 2006.
Date
Account
12/31/06 Bond interest expense
Premium on bonds payable
Interest payable
Debit
$4,297
703
Credit
$5,000
To record bond interest expense, amortization of premium and accrued
bond interest payable at December 31, 2006
Costs of Issuing Bonds
The costs involved in issuing bonds should be capitalized as a deferred charge and amortized
over the life of the bonds. Although the effective interest method would be GAAP the amounts
are not material so most entities use the straight-line method.
Example: Spencer Company issued 500, $1,000 5-year bonds at par on July 1, 2006. The costs
associated with this bond issue were $20,000. The company uses the straight-line method of
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Bonds and Long-Term Notes
amortizing bond issue costs. The journal entry to record the bond issue on July 1, 2006 would be
as follows:
Date
7/1/06
Account
Debit
$480,000
20,000
Credit
Cash
Unamortized bond issue costs
Bonds payable
$500,000
To record the issuance of 500, $1,000 5-year bonds on July 1, 2006
The journal entry to record the amortization of bond issue cost on December 31, 2006 would be
as follows:
Date
Account
Debit
Credit
12/31/06 Bond issue expense
$2,000
Unamortized bond issue costs
$2,000
To amortize the bond issue costs for the six months ended December 31,
2006
Analysis of bond issue expense:
Unamortized bond issue costs
Year of straight-line amortization
Annual depreciation
Number of months in 2006
Amortization for 2006
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$20,000
5
4,000
6/12
$2,000
11