Redeeming bonds payable
Bonds may be (1) paid at maturity, (2) called, or (3) purchased in the market and retired. Bonds may also be retired by being converted into stock. Each action is either a redemption of bonds or the extinguishment of debt. A company that pays its bonds at maturity would have already amortized any related discount or premium and paid the last interest payment. The only entry required at maturity would debit Bonds Payable and credit Cash for the face amount of the bonds
An issuer may redeem some or all of its outstanding bonds before maturity by calling them. The issuer may also purchase bonds in the market and retire them. In either case, the accounting is the same. Watch this video to see how we retire bonds when the the bond was originally issued at a discount.
In the video example, the carrying value of the bonds are $61,750 calculated as Bonds Payable $65,000 – Discount on Bonds Payable remaining $3,250. The cash we paid to retire the bonds is $66,150 which is greater than the carrying value of the bond of $61,750 so we are paying more to retire the bond than it is worth and we record a loss for the difference of $4,400 ($66,150 – $61,750). If the cash we paid is less the carrying value of the bonds, we are paying less than the bonds are worth so we get to record a gain on the retirement of the bonds. Let’s look at another example.
Assume that on January 1, Carr calls bonds with a $10,000 face value and remaining premium on bonds payable of $272. Carr pays cash of $10,300 to retire these bonds. The carrying value on the bonds is $10,272 ($10,000 bonds payable + $272 premium on bonds payable) and we are paying cash of $10,300 which is more than the carrying value of the bonds. We will record a loss for the difference $28 ($10,300 cash- $10,272 carrying value). In the required entry, we must remove the bond and its related accounts, in this case, premium on bonds payable by debiting both accounts. The required entry is:
| Debit | Credit | ||
| Jan 1 | Bonds Payable | 10,000 | |
| Premium on Bonds Payable | 272 | ||
| Loss on Retirement of Debt ($10,300 cash – 10,272 carrying value) | 28 | ||
| Cash | 10,300 | ||
| To record bond redemption at a loss. |
According to FASB Statement No. 4, gains and losses from voluntary early retirement of bonds are extraordinary items, if material. We report such gains and losses in the income statement, net of their tax effects, as described in Unit 15. The FASB is currently reconsidering the reporting of these gains and losses as extraordinary items.
A company may add to the attractiveness of its bonds by giving the bondholders the option to convert the bonds to shares of the issuer’s common stock. In accounting for the conversions of convertible bonds, a company treats the carrying value of bonds surrendered as the capital contributed for shares issued.
Suppose a company has $10,000 face value of bonds outstanding. Each $1,000 bond is convertible into 50 shares of the issuer’s $10 par value common stock so the $10,000 face value (10 bonds x $1,000 each) would convert to 500 shares (10 bonds x 50 shares per bond). On May 1, when the carrying value of the bonds was $9,800 (meaning $10,000 bonds payable – $200 discount on bonds payable balance), investors presented all of the bonds for conversion. The entry required is:
| Debit | Credit | ||
| May 1 | Bonds Payable | 10,000 | |
| Discount on Bonds Payable | 200 | ||
| Common Stock (500 shares x $10 par) | 5,000 | ||
| Paid in capital in excess of par value, Common | 4,800 | ||
| To record conversion of bonds to common stock. |
The entry eliminates the $9,800 book value of the bonds from the accounts by debiting Bonds Payable for $10,000 and crediting Discount on Bonds Payable for $200 (remember, discount on bonds payable is a contra-liability account and has a normal debit balance). It credits Common Stock for the par value of the $5,000 shares issued (500 shares x $10 par). The excess amount ($10,000 – 200 – 5,000 = $ 4,800) is credited to Paid-In Capital in Excess of Par Value—Common.
Accounting in the Headlines
How does a convertible bond issued by Fiat Chrysler Automobile affect the company’s balance sheet?
Fiat Chrysler Automobiles (FCA) launched a $2.5 billion convertible bond issue in December 2014. FCA will be using the funds generated from the bond issue to help to turn its Jeep, Maserati, and Alfa Romeo brands into global brands, competing directly against Volkswagen and BMW in the premium car market.
The bond issue will mature in 2016 and will pay annual interest (an “annual coupon”). The bond will have a conversion feature that allows it to be converted into shares; an investor would presumably exercise the conversion right if the market price of FCA rises to an appropriate level at some future date. If the market price does not increase suitably, then the bondholder would simply hold the bond without converting it into FCA stock.
Questions
- Is the convertible bond accounted for as liability or as equity by FCA? Why?
- How will the convertible bond issue affect FCA’s assets, liabilities, and equity?
- Assume that investors opt to convert the bond into stock in late 2015. How will that conversion affect FCA’s assets, liabilities, and equity?