- Record the entries associated with a bond issue sold at face value
Usually, companies sell their bond issues through an investment company or a banker called an underwriter. The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by selling the bonds for more than the fixed price.
When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to the bond indenture provisions is in default. If that happens the trustee takes action to force the issuer to comply with the indenture.
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 percent 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:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Dec 31 | Cash | 100,000 | ||
| Dec 31 | Bonds Payable | 100,000 | ||
| Dec 31 | To record bonds issued at face value. |
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):
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Jun 30 | Bond Interest Expense ($100,000 x 12% x 6 months / 12 months) | 6,000 | ||
| Jun 30 | Cash | 6,000 | ||
| Jun 30 | To record semiannual interest payment. |
On December 31 (10 years later), the maturity date, the entry would include the last interest payment and the amount of the bond:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Dec 31 | Bond Interest Expense ($100,000 x 12% x 6 months / 12 months) | 6,000 | ||
| Dec 31 | Bonds Payable | 100,000 | ||
| Dec 31 | Cash | 106,000 | ||
| Dec 31 | To record final semiannual interest and bond repayment. |
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 the 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:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Dec 31 | Bond Interest Expense ($100,000 x 12% x 2 months / 12 months) | 2,000 | ||
| Dec 31 | Interest Payable (or Bond Interest Payable) | 2,000 | ||
| Dec 31 | To record accrued interest for November and December payable in April. |
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.
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Dec 31 | Bond Interest Expense ($100,000 x 12% x 4 months / 12 months) | 4,000 | ||
| Dec 31 | Interest Payable (or Bond Interest Payable) | 2,000 | ||
| Dec 31 | Cash ($100,000 x 12% x 6 months / 12 months) | 6,000 | ||
| Dec 31 | To record payment of 6 months bond interest. |
Since the 6-month period ending October 31 occurs within the same fiscal year, the bond interest entry would be:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| Oct 15 | Bond Interest Expense ($100,000 x 12% x 6 months / 12 months) | 6,000 | ||
| Oct 31 | Cash | 6,000 | ||
| Oct 31 | To record semiannual interest payment. |
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.
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:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| May 31 | Cash | 105,000 | ||
| May 31 | Bonds payable | 100,000 | ||
| May 31 | Bond interest payable ($100,000 x 12% x (5/12)) | 5,000 | ||
| May 31 | To record bonds issued at face value plus accrued interest. |
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:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| June 30 | Bond Interest Expense ($100,000 x 0.12 x (1/12)) | 1,000 | ||
| June 30 | Bond interest payable | 5,000 | ||
| June 30 | Cash | 6,000 | ||
| June 30 | To record bond interest payment. |
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.