13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds

Accounting for Bonds

Bonds are one of the primary ways companies raise long-term capital. The accounting for bonds depends on the relationship between the market (effective) interest rate and the stated (coupon) interest rate at the time of issuance. That relationship determines whether bonds are issued at par, at a premium, or at a discount, and it shapes every journal entry from issuance through retirement.

Bond Issuance at Par vs. Premium vs. Discount

The price investors are willing to pay for a bond depends on how its stated rate compares to the current market rate. Think of it this way: if a bond promises 6% interest but the market only demands 4%, investors will pay more than face value to get that higher rate. The reverse is also true.

At Par (market rate = stated rate):

• Debit Cash for the face value
• Credit Bonds Payable for the face value

No premium or discount exists because the two rates match.

At a Premium (market rate < stated rate):

Investors pay more than face value because the bond's coupon is more attractive than what the market currently offers.

• Debit Cash for the total amount received (face value + premium)
• Credit Bonds Payable for the face value
• Credit Premium on Bonds Payable for the premium amount

At a Discount (market rate > stated rate):

Investors pay less than face value because the bond's coupon is lower than what the market currently demands.

• Debit Cash for the amount received (face value − discount)
• Debit Discount on Bonds Payable for the discount amount
• Credit Bonds Payable for the face value

Premium on Bonds Payable is a contra-liability that increases the carrying value above face value. Discount on Bonds Payable is a contra-liability that decreases the carrying value below face value. Both get amortized to zero over the bond's life.

Interest Expense Calculation (Effective Interest Method)

The effective interest method ties interest expense to the bond's carrying value each period, which produces a more accurate measure of the true cost of borrowing. This is the method required under GAAP.

Two formulas drive every interest entry:

$\text{Interest Expense} = \text{Carrying Value} \times \text{Market (Effective) Interest Rate}$

$\text{Cash Payment} = \text{Face Value} \times \text{Stated Interest Rate}$

The difference between these two amounts is the premium or discount amortization for that period.

For a Premium Bond (interest expense < cash payment):

1. Debit Interest Expense (carrying value × market rate)
2. Debit Premium on Bonds Payable (cash payment − interest expense)
3. Credit Cash (face value × stated rate)

Each period, the premium balance shrinks, which lowers the carrying value toward face value.

For a Discount Bond (interest expense > cash payment):

1. Debit Interest Expense (carrying value × market rate)
2. Credit Discount on Bonds Payable (interest expense − cash payment)
3. Credit Cash (face value × stated rate)

Each period, the discount balance shrinks, which raises the carrying value toward face value.

Building an amortization schedule is the best way to track these changes. Each row shows the period's interest expense, cash payment, amortization amount, and updated carrying value. By the final period, the carrying value should equal the face value exactly.

Bond Retirement and Amortization Entries

Retirement at Maturity

If the premium or discount has been fully amortized (as it should be by the final interest payment), the entry is straightforward:

• Debit Bonds Payable for the face value
• Credit Cash for the face value

If for any reason a small premium or discount balance remains at maturity, you clear it with the final interest entry:

• Remaining premium: Debit Premium on Bonds Payable, Credit Interest Expense
• Remaining discount: Debit Interest Expense, Credit Discount on Bonds Payable

Early Retirement (Before Maturity)

A company may choose to retire bonds early by repurchasing them on the open market or calling them. The key steps are:

1. Record any accrued interest up to the retirement date.

2. Amortize the premium or discount up to the retirement date.

3. Compare the bond's carrying value to the cash paid to reacquire it.

   • If cash paid < carrying value → record a Gain on Bond Retirement (credit)
   • If cash paid > carrying value → record a Loss on Bond Retirement (debit)

4. Remove Bonds Payable and any remaining premium or discount from the books.

Additional Considerations

• Accrual basis accounting applies to all bond transactions. Interest expense is recognized in the period it's incurred, regardless of when cash is actually paid.
• Present value calculations determine the issue price of bonds sold at a premium or discount. The issue price equals the present value of all future cash payments (interest + principal), discounted at the market rate.
• The stated rate determines the cash payment each period; the market rate determines the interest expense. Keeping these two roles straight is essential for getting journal entries right.