2.1 Bond Issuance, Valuation, and Amortization

Bond Issuance, Valuation, and Amortization

Bonds are one of the primary ways companies raise large amounts of capital without issuing stock. A company borrows money from investors, pays them interest along the way, and returns the principal at maturity. Getting the accounting right requires understanding how bonds are priced, how premiums and discounts arise, and how those amounts get amortized over the bond's life.

Bond Issuance and Accounting

The Bond Issuance Process

A bond is a long-term debt instrument issued by corporations (and governments) to raise capital for things like expansion, acquisitions, or infrastructure. When a company issues bonds, it makes two promises to bondholders:

• Periodic interest payments (called coupon payments), typically semiannual
• Repayment of the face value (also called par value) at the maturity date

The bond indenture is the legal contract governing the bond issue. It spells out the face value, the stated coupon rate, the maturity date, and any special features like call provisions (the issuer's right to repay early) or conversion options (the bondholder's right to convert into stock).

Accounting for Bond Issuance

When bonds are issued, the company receives cash and takes on a long-term liability. The journal entry depends on whether the bonds sell at par, at a premium, or at a discount.

• Issued at par: Cash received equals face value. The entry is straightforward: debit Cash, credit Bonds Payable.
• Issued at a premium or discount: The difference between cash received and face value gets recorded in a separate account (Premium on Bonds Payable or Discount on Bonds Payable). That premium or discount is then amortized over the bond's life, which we'll cover below.

Bond Valuation and Pricing

Calculating the Present Value of Bonds

The issue price of a bond equals the present value of its future cash flows, discounted at the market interest rate (also called the yield or effective rate). The market rate reflects what investors demand for bonds of similar risk and maturity.

A bond has two streams of future cash flows:

1. The annuity of coupon payments (received each period)
2. The lump-sum face value (received at maturity)

The general present value formula:

$PV = \sum_{t=1}^{n} \frac{C}{(1 + r)^t} + \frac{F}{(1 + r)^n}$

Where:

• $C$ = periodic coupon payment (face value × stated rate per period)
• $r$ = market interest rate per period
• $t$ = period number for each coupon payment
• $F$ = face value
• $n$ = total number of periods until maturity

In practice, you'll typically use present value tables or a financial calculator. The coupon stream uses the present value of an annuity factor, and the face value uses the present value of a single sum factor.

Determining the Issue Price

The relationship between the stated coupon rate and the market rate determines whether a bond sells at par, a premium, or a discount:

The logic is intuitive. If a bond pays a 6% coupon but the market only demands 4%, investors will pay more than face value to get that above-market coupon. Conversely, if the market demands 8% but the bond only pays 6%, investors will pay less than face value to compensate for the below-market coupon.

Amortization of Bond Premiums and Discounts

The Effective Interest Method

The effective interest method is the required approach under GAAP for amortizing premiums and discounts. It produces a constant interest rate each period (the market rate at issuance) applied to a changing carrying value.

Here's how it works each period:

1. Calculate interest expense: Multiply the bond's carrying value at the beginning of the period by the market (effective) interest rate.
2. Determine the cash coupon payment: This is fixed (face value × stated rate per period) and doesn't change.
3. Compute the amortization amount: The difference between interest expense (step 1) and the cash coupon payment (step 2) is the premium or discount amortization for that period.
4. Update the carrying value: Adjust the carrying value by the amortization amount.

By maturity, the carrying value will equal the face value exactly, because the entire premium or discount has been amortized.

Amortization of Premiums and Discounts

For bonds issued at a premium:

• Interest expense (carrying value × market rate) is less than the coupon payment
• The difference reduces the Premium on Bonds Payable each period
• The carrying value decreases toward face value over time

For bonds issued at a discount:

• Interest expense (carrying value × market rate) is greater than the coupon payment
• The difference reduces the Discount on Bonds Payable each period
• The carrying value increases toward face value over time

One thing to keep straight: amortization affects the interest expense recognized on the income statement and the carrying value on the balance sheet, but it does not change the actual cash coupon payments made to bondholders. Cash payments stay the same every period.

Journal Entries for Bond Transactions

Recording Bond Issuance

At par (e.g., $100{,}000$ face value bonds issued at 100):

At a premium (e.g., $100{,}000$ face value bonds issued at 104, receiving $104{,}000$):

At a discount (e.g., $100{,}000$ face value bonds issued at 96, receiving $96{,}000$):

Note that Discount on Bonds Payable is a contra-liability account (it carries a debit balance and reduces the carrying value of Bonds Payable on the balance sheet).

Recording Interest Payments and Amortization

Under the effective interest method, the interest payment and amortization are typically recorded together. Suppose a bond issued at a premium has a carrying value of $104{,}000$, a market rate of 4% semiannually, and a coupon payment of $5{,}000$:

1. Interest expense: $104{,}000 \times 0.04 = 4{,}160$
2. Cash coupon payment: $5{,}000$
3. Premium amortization: $5{,}000 - 4{,}160 = 840$

For a discount bond, the entry flips: interest expense exceeds the cash payment, and the difference credits (reduces) the Discount on Bonds Payable.

Recording Bond Retirement

At maturity, the carrying value equals face value (all premium/discount has been amortized):

Early retirement (before maturity) requires comparing two amounts:

• The reacquisition price (what the company pays to buy back the bonds)
• The carrying value at the date of retirement

If the carrying value exceeds the reacquisition price, the company records a gain on retirement. If the reacquisition price exceeds the carrying value, it records a loss on retirement. Any remaining unamortized premium or discount is removed as part of the entry.