Bonds Payable
Bonds payable are financial instruments representing a company’s commitment to pay back a specified sum to the owner of the instrument in a specified time together with periodic interest payments over the life of the bond.
The time span in which a company has to pay back the principal and the interest is called the maturity of the bond (also called term of the bond). The periodic interest payments are called coupon payments, which are based on the rate of interest specified in the bond. The rate is called coupon rate (also called contract rate or stated rate).
Bonds payable are governed by a contract called the bond indenture which specifies the terms of the bond such as maturity, repayment schedule, etc. and specifies any covenants. Positive covenants are certain obligations which the company has to fulfill during the term of bond, for example a bond indenture may require a company to maintain a times interest earned ratio of at least 3. Negative covenants are restrictions on the company; for example, a bond indenture may require a company not to have a dividend payout ratio in excess of 40%.
Bond Issuance
The amount at which bonds payable are issued depends on the difference between the coupon rate and the actual interest rate prevailing in the market.
If the coupon rate is higher than the market interest rate, the bonds are issued at a price higher than the face value i.e. at a premium. Such issuance is journalized as follows:
| Cash | A+B | |
| Bonds payable | A | |
| Bond premium | B |
Similarly, if the coupon rate is lower than the market interest rate, the bonds are issued at a discount i.e. for cash proceeds that are lower than the face value.
| Cash | B | |
| Bond discount | A - B | |
| Bonds payable | A |
If the coupon rate and the market interest rate are the same, the bonds payable are issued at their face value. Issue of bonds payable at par is recorded as:
| Cash | F | |
| Bonds payable | F |
Coupon Payments
Coupon payments are periodic interest payments a company makes to its bond-holders. Coupon payments are calculated as follows:
| Coupon Payments = FV × | c |
| n |
Where
FV = face value of the bond i.e. the principal amount
c = annual coupon rate, i.e. the stated or contract interest rate
n = number of coupon payments per year
Coupon payments are booked as follows:
| Bond interest expense | I | |
| Cash | I |
Balance Sheet Presentation
In case of bond issued on premium, carrying value of bonds as reported on balance sheet is greater than their face value. Similarly, in case of issue at discount, carrying value is less than the face value.
| Bonds payable face value | FV |
| Add: bond premium (if any) | BP |
| Less: bond discount (if any) | BD |
| Bonds payable carrying value on balance sheet | CV |
Income Statement Presentation
Income statement reports bond interest expense which represents cost of funds obtained through issuance of bonds. It equals coupon payment as adjusted for amortization of bond discount/premium as shown in the formula below:
| Coupon payments (FV × c / n) during the period | CP |
| Add: any amortization of bond discount | ABD |
| Less: any amortization of bond premium | ABP |
| Bond interest expense (as on income statement) | IE |
Example: Journal Entries
On 1 January 2001, Codestreet, Inc. issued 100,000, $100 face value bonds carrying a coupon rate of 8% payable semiannually. The term of the bonds is 20 years. Journalize issuance of bonds and the first semi-annual payment.
Solution
Since there is no indication that the bonds were issued at either premium or discount, so the journal entry to record the bonds shall be:
| Cash/Bank | $10 M | |
| Bonds payable | $10 M |
The periodic interest payments equal the face value multiplied by the coupon rate applicable. In this scenario annual coupon rate is 8% but the bond will pay two payments each year so each periodic payment is $400,000 (= 8% ÷ 2 × $100 × 100,000).
| Bond interest expense | $0.4 M | |
| Cash/Bank | $0.4 M |
by Obaidullah Jan, ACA, CFA and last modified on