BONDS
Accounting Theory
A bond is a long-term obligation of the borrower to the lender. The lender holds the documents evidencing the
future claim. The bond is a promise to pay a specified principal amount at a stated date with interest at a
specified rate at stated dates. When a bond is purchased as an investment it is an asset. When a bond is sold it is
a liability. Bonds are classified as permanent provided management does not have the intention to convert them
to working capital in the near future. The proceeds of the bonds issue must be for purposes other than current
operations,
Bonds intended to be held for long periods of time are classified on the balance sheet as Investments and Funds
if an asset and Long-Term Liabilities if a liability. A bond issue is stated in the number of units by denominations
usually consisting of $1,000 maturity amount. Interest payments are usually semiannual and the interest rate is
expressed on an annual basis. The fair market of a bond fluctuates with interest rates and the maturity date of
the bonds. If interest rates rise the value of the bond falls. If interest rates fall the value of the bond rises. This
inverse relationship adjusts the stated rate of the bond to the yield rate. In addition to interest rate risk there is
market risk that a market will exist to trade the bond. There is also the risk that the bond issuer may be unable
to make the interest and principal payments.
Permanent investments in bonds are recorded at cost which is the market value of the bond. If the bonds are
purchased between interest dates the price will include accrued interest. The price of the bond can include a
premium or discount depending on interest rates and the maturity date. The premium and discount is amortized
over the life of the bond. The amortization of premium and discount results in bringing the carrying value of the
bonds into agreement with the maturity amount and also adjusts the interest from the stated amount to the
effective yield.
When a substantial and permanent decline in market price has taken place the loss in market value is recorded
by a valuation allowance. Only when the long- investments are sold and the loss realized is the long-term
investment account credited. If long-term investments consists of only a single investment the allowance
account is adjusted at the time the long-term investment is sold because a loss was previously recorded at the
time of the material and permanent decline in market value.
If long-term investments consist of more than a single investment the balance in the allowance account is
ignored when a long-term investment is sold. The allowance account is adjusted at the end of the year to report
the excess of cost over market value. If there is a further loss of market value the allowance account is credited. If
there is a recovery in market value the allowance account is debited.
Subsequent gains in market value above cost are not recorded because of the exception principle for
conservatism and the concept of lower of cost or market.
Interest income from investments both temporary and long-term is reported as non operating income. Interest
expense is recorded as to the use of the bonds proceeds. Gains and losses from the sale of long-term investments
are recorded as extraordinary items. A material and permanent decline in the market value of long-term
investments is reported as an extraordinary item.
Market Value of Bonds
The market value of a bond is the present value of the principal and the present value of the interest
payments. The present value of the principal is determined by discounting the principal at the yield rate of
interest from the time of purchase through maturity...present value of one. The present value of the interest
since the interest is equal periodic payments is the discounted present value of the periodic payments at the yield
rate of interest...present value of an ordinary annuity of one. The sum of each present value is the present value
of the bond. Bond tables are available that comprise these two values over a term of years so that bond prices and
bond yields can be determined.
BONDS
Amortization of Bond Premium and Bond Discount
Straight Line Amortization
The total discount or premium is of equal amounts for each period between the date of purchase and maturity
date. The amortization is the same for each period.
A bond amortization schedule should be done amortizing the discount and premium and reporting the interest
and carrying value of the bond. The dates on the bond amortization schedule are the dates the interest
payments are due. A second bond schedule should be done when the date of interest payments are not the same
as the fiscal dates of the company. That schedule will provide any accruals that need to be recorded are the end
of fiscal periods.
Amortization of Bond Premium and Bond Discount
Present Value Amortization
The total discount or premium is amortized based on the yield rate and nominal rate of interest of the bonds.
The rate is constant not the dollar amount of amortization as per the straight line method of amortization. The
present value method of amortizing views the discount or premium as the amount of an annuity. The amount of
amortization in any period is the present value of the annuity. The difference between the yield rate on the
carrying value of the bond and the nominal rate on the par value of the bond is the amortization.
A bond amortization schedule should be done amortizing the discount and premium and reporting the interest
and carrying value of the bond. The dates on the bond amortization schedule are the dates the interest
payments are due. A second bond schedule should be done when the date of interest payments are not the same
as the fiscal dates of the company. That schedule will provide any accruals that need to be recorded are the end
of fiscal periods.
A bond that has an interest rate yield greater than the interest rate stated on the bond is sold at a discount. A
bond that has an interest rate yield less than the interest rate stated on the bond is sold at a premium. For
example a $100,000 bond has an annual interest rate stated on the bond of 5% with interest paid semiannually.
When the bond is sold the yield interest rate is 6% therefore the bond was sold at a discount. The bond is for 5
years. How is the discount calculated and how is it amortized:
Amount of the Bond $100,000.00
Present Value of 1
Ten semiannual periods 3% .74409391
Present Value of the Bond Principal $74,409.39
Semiannual interest at stated interest rate 2.5% $2,500.00
Present Value of an Annuity of 1
Ten semiannual periods 3% 8.5302028
Present Value of the Bond Interest $21,325.51
Total Present Value $95,734.90
Illustration
Accrued Interest
Bonds Purchased Between Interest Dates
These bonds will include accrued interest as part of the total consideration paid for the bonds. The accrued
interest is a reduction of the interest for the first semiannual payment.
BONDS
Accrued Interest
Bonds Sold Between Interest Dates
These bonds will include accrued interest through the date of sale as part of the total consideration received from
the sale of bonds. The proceeds received minus the accrued interest minus the carrying value of the bonds is the
gain or loss on the sale of the bonds. To have the correct carrying value of the bonds the discount or premium
must be amortized through the date of sale.
When bonds are sold that are a portion of the bonds held new bond schedules should be prepared that account
for the bonds sold and the bonds not sold. The bonds sold will include accrued interest through the date of sale
as part of the total consideration received from the sale of bonds. The proceeds received minus the accrued
interest minus the carrying value of the bonds is the gain or loss on the sale of the bonds. To have the correct
carrying value of the bonds the discount or premium must be amortized through the date of sale.
Bonds Callable Before Maturity
The bond contract may allow the issuer to call the bonds for payment before maturity. A callable bond. The call
price can be the maturity amount or an excess of the maturity amount.
Bonds Callable Before Maturity
Bond Purchased at a Premium
When a call provision is included in a bond issue the cost of the bond over the call amount is the amount of the
premium to be amortized. The period of amortization is the purchase date through the date of the call. If the
bonds were not called the balance of the premium is amortized over the remaining term of the bonds or the
period until the next call date. For example if a (25) year bond in the amount of $100,000 is sold at $110,000
and there is a call provision at the end of year (15) at $102,000...the premium to be amortized is $8,000 over
(15) years. If the bond is not called at the end of (15) years the balance to be amortized of $2,000 will be done
over the remaining term of (10) years.
Bonds Callable Before Maturity
Bond Purchased at a Discount
When the bond is purchased at a discount and is callable at a premium only the discount should be amortized
unless it is definite that the bond will be called. For example if a (25) year bond in the amount of $100,000 is
sold at $95,000 and there is a call provision at the end of year (15) at $102,000...the discount to be amortized is
$5,000 over (25) years. If the bond is not called at the end of (15) years the balance to be amortized is $2,000.
It the bond is called at the end of (15) years the call price of $102,000 over the amortized value of the bond
investment (carrying value) of $98,000 will be a gain of $4,000 in the year of the call.
Bonds Defaulted
A borrower may default by not paying the interest, principal or both principal and interest. The carrying value of
the bond must be adjusted in the event of default in accordance with the exception principle of conservatism.
The bond investment should be reclassified from the investment account to another account at fair market value
and a loss recognized. Before valuation the lender will have to determine the possibility of any proceeds from
liquidation of the underlying bond security such as a mortgage. If the defaulted bonds are under the control of a
trustee the lender should consult with the trustee regarding valuation. Interest on bonds in default should not be
accrued.
If defaulted bonds are purchased the cost is the full amount paid including accrued interest. Any recovery of cost
should be accounted for under the sunk cost method. That is any receipts are a recovery of the investment cost
until there is a full recovery. If the borrower is able to restore solvency the bond investment may again be
reclassified and interest on the bonds can be accrued.
BONDS
Long-Term Bond Liabilities
Long-term liabilities are liabilities that will not mature within the following year or the operating cycle of the
business if longer than one year. Bonds maturing within the following year or operating cycle if longer than one
year should be classified as long-term liabilities if management intends that they be refunded or liquidated by
funds in noncurrent assets such as a sinking fund. Long-term liabilities should be incurred for the purpose of
securing a more permanent capital of the business such as fixed assets. A mortgage payable is a long-term
liability in the form of a note. The mortgage is a lien on the asset and serves as security for the amount
borrowed.
Classes of Bonds
Bonds are issued by private concerns and public entities such as the federal government and state and local
government.
Secured bonds are collateralized by a lien on specific assets. A Guaranty Security Bond is collateralized by a lien
on a specific asset and in the case of default principal and interest will be paid by the guarantor. A Lien Security
Bond is collateralized by a lien on specific assets such as securities, fixed assets, sinking funds and real estate.
Unsecured bonds called debenture bonds are not collateralized. There are no supporting liens.
Bonds are issued for the following purposes:
Purchase money bonds... for acquisition of capital assets.
Refunding bonds...to retire maturing obligations and usually have the same security as the bonds redeemed.
Funding bonds...to retire maturing of other long-term debt obligations.
Consolidated bonds...to replace prior issues and unite the securities for the retired issues.
How interest is paid depends on the type of bonds. Ordinary Bonds have a specified annual rate of interest
payable at the end of a period such as monthly, quarterly or semiannually. They are registered bonds held by the
broker of record or the holder of record. The payment of interest on Income Bonds depends on earning net
income. Participation bonds have a specified minimum rate of interest plus a participation in profits.
Bonds maturing at a fixed date all at one time are straight ordinary bonds. Bonds maturing at a fixed date in
stated installments are serial bonds. Callable or redeemable bonds allow the issuer (borrower) to retire them at
a stated price before the maturity date. Convertible bonds allow the lender to convert the bonds into specified
securities of the issuer (borrower).
Balance Sheet Reporting of Bonds Payable and Bond Issue Costs
When reporting Bonds Payable there are separate accounts for the principal or par amount of the debt and the
discount or premium. There is also a separate account for bond issue costs. The bond discount and premium
should be amortized by the present value method
A bond amortization schedule should be done amortizing the discount and premium and reporting the interest
and carrying value of the bond. The dates on the bond amortization schedule are the dates the interest
payments are due. A second bond schedule should be done when the date of interest payments are not the same
as the fiscal dates of the company. That schedule will provide any accruals that need to be recorded are the end
of fiscal periods.
Bond discount and bond premium are reported in the long-term liabilities section of the balance sheet as
adjustments to the bond payable. Treasury bonds reacquired but not cancelled are subtracted from bonds
payable on the balance sheet.
BONDS
Bond issue costs include legal fees for preparing documents and the bond indenture, printing costs, registration
and filing fees and commissions to the bond sellers. Bond issue costs are reported on the balance sheet as Assets
under the section deferred charges or other assets. They should be amortized in the same manner as the bond
discount or premium.
Bonds Payable Redeemed Before Maturity
If bonds payable are redeemed before maturity the unamortized bond discount, bond premium and bond issue
costs should be removed from the accounts. The difference between the carrying value of the bonds retired and
the redemption price should be recorded as a gain or loss on bond redemption.
When bonds are redeemed that are a portion of the bonds payable new bond schedules should be prepared that
account for the bonds redeemed and the bonds not redeemed. The bonds redeemed will include accrued interest
through the date of redemption as part of the total consideration paid for the redemption of bonds. The total
amount paid (redemption price) minus the accrued interest minus the carrying value of the bonds is the gain or
loss on the redemption of the bonds. To have the correct carrying value of the bonds the discount or premium
must be amortized through the date of redemption.
Bonds Payable Refunded Before Maturity
When bonds are refunded prior to maturity the accounting is not always a redemption whereby a gain or loss is
recorded. Costs to consider include the balance of unamortized bond discount and unamortized bond issue cost
of the bond issue being refunded and the call premium that must be paid to reacquire the bonds. When the
refunding occurs because of currently lower interest rates or anticipation of higher rates the expected benefits
justify spreading the costs over the issue term of the new issue as a financing cost. When the new issue is
essentially a continuation of the old, with a revised interest rate the cost is amortized over the life of the new
refunding issue as a financing cost. When the bonds payable are refunded for any other reason the cost is
recorded on the income statement as a nonrecurring extraordinary item net of current income taxes.
Convertible Bonds
Convertible bonds allow the lender (investor) to convert the bonds into specified securities of the issuer
(borrower). This is an action that accelerates the maturity date of the bond. In a rising market for common
stocks it appears convertible bonds provide an advantage for both the issuer and lender.
A conversion ratio specifies the number of shares of common stock the holder of the convertible security would
receive when the bonds are surrendered for conversion. The conversion price is the relationship between the par
or maturity value of the bond to the number of shares of common stock received. For example a bond issue
stated that each $1,000 bond could be converted to 25 shares of common stock. The conversion ratio is 25. The
conversion price is $40. The conversion ratio and conversion price are established when the convertible bond is
sold.
If a convertible security is called and the redemption price is below the market value of the common stock the
lender would benefit by converting the bond to common stock.
When a bond conversion is to be recorded any amortization of bond discount or premium is recorded to the date
of conversion. Accrued interest is recorded to the date of bond conversion. The conversion can be recorded
based on either of two methods:
Method One...Carrying value of the bond payable. The amortized value of the bond payable determines the book
value assigned to the stock. If the stock has a par or stated value and the amounts do not agree with the
amortized bond carrying value at the date of conversion the difference is recorded as a premium or discount on
the stock.
BONDS
Method Two...Market value of the bonds or market value of the stock. Whatever value is more clearly
determinable is the value assigned to the stock. There should not be much of a difference in the fair market
values of the convertible bonds and shares of stock received for the bonds.
For example holders of 100 bonds of $1,000 denominations exercise their right to convert to 2,500 shares of
$35 par value common stock. The unamortized bond premium at the date of conversion is $4,000. The
conversion ratio is 25 shares of stock for each bond. The conversion price is $40. The par value of the bonds is
$100,000. The par value of the stock is $87,500. The stock fair market value at the date of conversion is $45
share for a total fair market value of $112,500.
Under method one the entry to record the conversion is:
Bonds Payable $100,000
Bond Premium 4,000
Common Stock $87,500
Premium on Common Stock 16,500
The premium on common stock is 2,500 shares x $5 share = $12,500 + bond premium of $4,000
Under method two the entry to record the conversion is:
Bonds Payable $100,000
Bond Premium 4,000
Loss on Bond Conversion 8,500
Common Stock $87,500
Premium on Common Stock 25,000
The premium on common stock is 2,500 shares x $10 share = $25,000
The loss on bond conversion is because the market value of the stock exceeds the carrying value of the bonds at
the date of conversion. Value of each $1,000 bond is $104. Value of each of the 2,500 shares of stock is $45
($112,500 / 2,500 shares). The shares of common stock are 2.5 times the bond denomination which would
equate to$112.50. The loss on conversion is $8.50 per each $1,000 bond denomination ($112.5 - $104.00 =
$8.50) for each $1,000 of bond value.
The loss on conversion can also be calculated by the market value per share of stock $45 minus the conversion
price $40 equals $5 time the number of shares issued 2,500 equals $12,500 minus the bond premium of $4,000
equals $8,500 the loss on conversion.
Serial Bonds
Serial bonds allow for repayment in a series of installments. When there is a source of funding the repayments
the use of serial bonds is suitable for its intended purpose. If there is no source for funding the repayments a
sinking fund will have to be established. As with any bonds the market value of the bond is determined the same
as described above under the heading Market Value of Bonds except that separate calculations are done for each
series.
The market value is the sum of each of the series.
For example if serial bonds were issued carrying a 8% interest rate semiannually and are sold to yield a 7%
semiannually with maturities as follows...End of two years $40,000...End of three years $40,000...End of four
years $50,000...and End of five years $50,000...Total bond issue is $180,000. There are ten semiannual
periods and four series. Series one has four semiannual periods. Series two has six semiannual periods. Series
three has eight semiannual periods. Series four has ten semiannual periods.
BONDS
Present value of the serial payments are as follows with semiannual yield interest rate of 7% :
Semiannual
Interest PV Principal PV Interest
Series One $40,000 $1,600 $34,858 $5,877
Series Two $40,000 $1,600 $32,540 $8,526
Series Three $50,000 $2,000 $37,971 $13,748
Series Four $50,000 $2,000 $35,446 $16,633
Total Present Value $140,815 $44,784
Total present value of Series One $40,735
Total present value of Series Two $41,066
Total present value of Series Three $51,719
Total present value of Series Four $52,079
Total present value $185,599
Illustration
The bond discount or premium on serial bonds is amortized based on the straight line method or present value
method. The straight line method can be done in two separate ways depending on if the bond discount or
premium is known for each series.
Straight Line Amortization Bond Discount or Premium is Known:
Series One Four periods of $183.75 Total $735
Series Two Six periods of $177.67 Total $1,066
Series Three Eight periods of $214.88 Total $1,719
Series Four Ten periods of $207.90 Total $2,079
Total Amortization $5,599
Series 1 Series 2 Series 3 Series 4 Total
End of 12 months $367.50 $355.33 $429.75 $415.80 $1,568.38
End of 24 months $367.50 $355.33 $429.75 $415.80 $1,568.38
End of 36 months $355.34 $429.75 $415.80 $1,200.89
End of 48 months $429.75 $415.80 $845.55
End of 60 months $415.80 $415.80
Total $735.00 $1,066.00 $1,719.00 $2,079.00 $5,599.00
BONDS
Straight Line Amortization Bond Discount or Premium is Not Known: Amortization
Total Per Period
Series One Four periods $40,000 $160,000 160/1,300 $689.11 $172.28
Series Two Six periods $40,000 $240,000 240/1,300 $1,033.66 $172.28
Series Three Eight periods $50,000 $400,000 400/1,300 $1,722.77 $215.35
Series Four Ten periods $50,000 $500,000 500/1,300 $2,153.46 $215.35
Total $180,000 $1,300,000 1,300/1,300 $5,599.00
Outstanding Amortization
End of two periods 12 months $180.000 180/650 $1,550.49
End of four periods 24 months $180,000 180/650 $1,550.49
End of six periods 36 months $140.000 140/650 $1,205.94
End of eight periods 48 months $100,000 100/650 $861.39
End of ten periods 60 months $50,000 50/650 $430.69
Total $650,000 $5,599.00
Series 1 Series 2 Series 3 Series 4 Total
End of 12 months $344.56 $344.55 $430.69 $430.69 $1,550.49
End of 24 months $344.55 $344.55 $430.70 $430.69 $1,550.49
End of 36 months $344.56 $430.69 $430.69 $1,205.94
End of 48 months $430.69 $430.70 $861.39
End of 60 months $430.69 $430.69
Total $689.11 $1,033.66 $1,722.77 $2,153.46 $5,599.00
BONDS
Amortization of Premium on Serial Bonds - Present Value Amortization
Interest Interest
4.0% 3.5%
Cash Bond Carrying
Payments Interest Premium Payable Value
At Issue $185,599
End of 6 months $7,200 $6,496 $704 $184,895
End of 12 months $7,200 $6,471 $729 $184,166
End of 18 months $7,200 $6,446 $754 $183,412
End of 24 months $7,200 $6,419 $781 $182,631
End of 24 months $40,000 $40,000 $142,631
End of 30 months $5,600 $4,992 $608 $142,023
End of 36 months $5.600 $4,971 $629 $141,394
End of 36 months $40,000 $40,000 $101,394
End of 42 months $4,000 $3,549 $451 $100,943
End of 48 months $4,000 $3,533 $467 $100,476
End of 48 months $50,000 $50,000 $50,476
End of 54 months $2,000 $1,767 $233 $50,243
End of 60 months $2,000 $1,757 $243 $50,000
End of 60 months $50,000 $50,000 $0
Total $232,000 $46,401 $5,599 $180,000
Sinking Fund
Because the bonds are retired at maturities within the bond term the funds will not be in the sinking fund
earning interest for the full term of the bond issue. Therefore in addition to funding the principal additional
interest will have to be added. That is accomplished by calculating an amount of one for each maturity amount
from its maturity date to the last maturity date. First maturity is $40,000 thirty six months from last maturity
date. Second maturity is $40,000 twenty four months from last maturity date. Third maturity is $50,000
twelve months from last maturity. Fourth maturity is $50,000 at last maturity. The trustee uses 4% as the
interest rate of the fund earnings. Amount to be funded is:
6 periods $40,000 x 1.126162420 = $45,046
4 periods $40,000 x 1.082432160 = $43,297
2 periods $50,000 x 1.04040000 = $52,020
0 periods $50,000 x 1.00000000 = $50,000
Total $190,363
The amount of an annuity of one for ten periods at 2% is 10.9497210 amounting to equal periodic payments of
$17,385.19. Bond principle contributed to the sinking fund is $173,851.90 and interest earned by the fund is
$6,148.10 for a total funded amount of $180,000. If the actual interest earned is less than estimated the
difference will have to be added by the company to the next periodic payment. A bond sinking fund table should
be prepared based on the original interest rate of the fund’s earnings to determine if the actual interest earned is
less than estimated.
BONDS
Sinking Fund Table
Interest
Income
Periodic 2.0%
Cash Sinking Bond Sinking
Payments Interest Fund Payable Fund
End of 6 months $17,385.19 $0.00 $17,385.19 $17,385.19
End of 12 months $17,385.19 $347.70 $17,732.89 $35,118.08
End of 18 months $17,385.19 $702.36 $18,087.55 $53,205.63
End of 24 months $17,385.19 $1,064.11 $18,449.30 $71,654.93
End of 24 months $40,000 $31,654.93
End of 30 months $17,385.19 $633.10 $18,018.29 $49,673.22
End of 36 months $17,385.19 $993.46 $18,378.65 $68,051.87
End of 36 months $40,000 $28,051.87
End of 42 months $17,385.19 $561.04 $17,946.23 $45,998.10
End of 48 months $17,385.19 $919.96 $18,305.15 $64,303.25
End of 48 months $50,000 $14,303.25
End of 54 months $17,385.19 $286.07 $17,671.26 $31,974.51
End of 60 months $17,385.19 $640.30 $18,025.49 $50,000.00
End of 60 months $50,000 $0.00
Total $173,851.90 $6,148.10 $180,000.00 $180,000
Small Business is the Engine that Drives our Economy. The Men and Women who Work to make our Country Great
Should be Recognized for their Achievement and Courage in Very Difficult Economic Times.