When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest date and issued at face value between interest dates.

Bonds issued at face value on an interest date Valley Company’s accounting year ends on December 31. On 2010 December 31, Valley issued 10-year, 12 per cent bonds with a $100,000 face value, for $100,000. The bonds are dated December 31, call for semiannual interest payments on June 30 and December 31, and mature in 10 years on December 31. Valley made the required interest and principal payments when due. The entries for the 10 years are as follows:

On December 31, the date of issuance, the entry is:

On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry would be (Remember, calculate interest as Principal x Interest x Frequency of the Year):

On December 31 (10 years later), the maturity date, the entry would include the last interest payment and the amount of the bond:

Note that Valley does not need any interest adjusting entries because the interest payment date falls on the last day of the accounting period. The income statement for each of the 10 years would show Bond Interest Expense of $12,000 ($ 6,000 x 2 payments per year); the balance sheet at the end of each of the years 1 to 8 would report bonds payable of $100,000 in long-term liabilities. At the end of ninth year, Valley would reclassify the bonds as a current liability because they will be paid within the next year.

The real world is more complicated. For example, assume the Valley bonds were dated October 31, issued on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on December 31 to accrue interest earned for November and December but not paid until April 30 of the next year. That entry would be:

The April 30 entry in the next year would include the accrued amount from December of last year and interest expense for Jan to April of this year.  We will credit cash since we are paying cash to the bondholders.

Since the 6-month period ending October 31 occurs within the same fiscal year, the bond interest entry would be:

Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest. The firm would report the $2,000 Bond Interest Payable as a current liability on the December 31 balance sheet for each year.

It would be nice if bonds were always issued at the par or face value of the bonds.  But, certain circumstances prevent the bond from being issued at the face amount.  We may be forced to issue the bond at a discount or premium.  This video will explain the basic concepts and then we will review examples:

Bond prices and interest rates

The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a premium. The amount a bond sells for below face value is a discount. A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and demand for, money.

Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate.

As shown above, if the market rate is lower than the contract rate, the bonds will sell for more than their face value. Thus, if the market rate is 10% and the contract rate is 12%, the bonds will sell at a premium as the result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate is 14% and the contract rate is 12%, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the market rate of interest on their investment.

Computing long-term bond prices involves finding present values using compound interest. Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The price investors pay for a given bond issue is equal to the present value of the bonds.

Issuers usually quote bond prices as percentages of face value—100 means 100% of face value, 97 means a discounted price of  97%of face value, and 103 means a premium price of 103% of face value. For example, one hundred $1,000 face value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value (or principal amount) of the bonds.

Bonds issued at a discount When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back.  We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond.  The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable.  This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond.  The discount will increase bond interest expense when we record the semiannual interest payment.  Here is a video example and then we will do our own example:

For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 95 1/2 or 95.50% with interest to be paid semi-annually on June 30 and December 30 for cash.  We know this is a discount because the price is less than 100%.  The entry to record the issue of the bond on January 1 would be:

In the balance sheet, the bonds would be reported with a carrying value equal to the cash received of $95,500 reported  as:

When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments.  The bond pays interest every 6 months on June 30 and December 31.  We will amortize the discount using the straight-line method meaning we will take the total amount of the discount and divide by the total number of interest payments.  In this example the discount amortization will be $4,500 discount amount / 6 interest payment (3 years x 2 interest payments each year).  The entry to record the semi-annual interest payment and discount amortization would be:

At maturity, we would have completely amortized or removed the discount so the balance in the discount account would be zero.  Our entry at maturity would be:

Bonds issued at a premium When we issue a bond at a premium, we are selling the bond for more than it is worth.   We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond.  The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable.  Just like with a discount, we will remove the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond.  The premium will decrease bond interest expense when we record the semiannual interest payment.  Here is a video example and then we will do our own example:

For our example assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 105 1/4 or 105.25% with interest to be paid semi-annually on June 30 and December 30 for cash.  We know this is a discount because the price is less than 100%.  The entry to record the issue of the bond on January 1 would be:

The carrying value of these bonds at issuance is equal to the cash received of $105,250, consisting of the face value of $100,000 and the premium of $5,250. The premium is an adjunct account shown on the balance sheet as an addition to bonds payable as follows:

Remember, when a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments.  A premium decreases the amount of interest expense we record semi-annually.  In our example, the bond pays interest every 6 months on June 30 and December 31.  We will amortize the premium using the straight-line method meaning we will take the total amount of the premium and divide by the total number of interest payments.  In this example the premium amortization will be $5,250 discount amount / 6 interest payment (3 years x 2 interest payments each year).  The entry to record the semi-annual interest payment and discount amortization would be:

Just like with a discount, we would have completely amortized or removed the premium so the balance in the premium account would be zero.  Our entry at maturity would be:

Bonds issued at face value between interest dates Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest”. The issuer must pay holders of the bonds a full six months’ interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check.

Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on May 31, instead of on December 31. The entry required is:

This entry records the $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.

The entry required on June 30, when the full six months’ interest is paid, is:

This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.