11.3 Bonds payable

Types of bonds

Bonds are a form of long-term debt financing commonly used by corporations and governments to raise capital. Different types of bonds carry varying features, risks, and benefits, all of which affect how they're accounted for and presented in the financial statements.

Secured vs unsecured bonds

Secured bonds are backed by specific assets pledged as collateral, such as real estate or equipment. This collateral reduces risk for investors because, if the issuer defaults, secured bondholders have a direct claim on those pledged assets.

Unsecured bonds (also called debentures) aren't backed by specific assets. They rely entirely on the issuer's general creditworthiness. In a default, unsecured bondholders have only a general claim on the issuer's assets with no priority over other general creditors.

Convertible vs non-convertible bonds

Convertible bonds give bondholders the option to convert their bonds into a specified number of shares of the issuer's common stock at a predetermined conversion price. This feature provides potential upside if the company's stock price rises significantly, which is why convertible bonds typically carry a lower stated interest rate than otherwise comparable non-convertible bonds.

Non-convertible bonds lack this conversion feature and are simply repaid in cash at maturity.

Callable vs non-callable bonds

Callable bonds give the issuer the right to redeem the bonds before maturity at a specified call price (usually above face value). Issuers typically exercise this option when market interest rates drop, allowing them to refinance at a lower cost.

Non-callable bonds don't have this early redemption feature and remain outstanding until maturity.

Term vs serial bonds

• Term bonds mature all at once on a single date, with interest paid periodically (annually or semi-annually) throughout their life.
• Serial bonds mature in installments over time, with a portion of the principal repaid at each scheduled maturity date. This structure spreads out repayment and reduces the issuer's refinancing risk compared to a single lump-sum repayment.

Issuing bonds payable

When a company issues bonds, it receives cash from investors in exchange for a promise to pay periodic interest and repay the principal at maturity. The price investors are willing to pay depends on the relationship between the bond's stated (coupon) interest rate and the market (effective) interest rate at the time of issuance.

At face value

Bonds are issued at face value (par) when the stated rate equals the market rate. The cash received equals the face value of the bonds, and no discount or premium exists.

At a discount

Bonds are issued at a discount when the stated rate is below the market rate. Investors aren't willing to pay full face value for below-market interest payments, so the proceeds are less than the face value. The difference is recorded as Discount on Bonds Payable, a contra-liability account that reduces the carrying value of the bonds on the balance sheet.

At a premium

Bonds are issued at a premium when the stated rate exceeds the market rate. Investors are willing to pay more than face value for above-market interest payments, so the proceeds exceed the face value. The excess is recorded as Premium on Bonds Payable, an adjunct liability account that increases the carrying value of the bonds on the balance sheet.

Accounting for bonds payable

Accounting for bonds payable involves two main tasks: initially recording the liability at the issuance price, then amortizing any discount or premium over the bond's life so that the carrying value equals the face value at maturity.

Present value of future cash flows

The issuance price of a bond equals the present value of all its future cash flows, discounted at the market interest rate. Those cash flows include:

• The periodic interest payments (an annuity)
• The principal repayment at maturity (a lump sum)

For example, suppose a company issues a 5-year, $\$100{,}000$ bond with a 6% stated rate, paying interest semi-annually, when the market rate is 8%. You'd discount 10 semi-annual interest payments of $\$3{,}000$ each ($\$100{,}000 \times 6\% \times \frac{1}{2}$) and the $\$100{,}000$ lump sum, both at 4% per period ($8\% \div 2$). Because the market rate exceeds the stated rate, the present value will be less than $\$100{,}000$, and the bond is issued at a discount.

Effective-interest method of amortization

The effective-interest method is the preferred (and more theoretically correct) approach. Here's how it works each period:

1. Calculate interest expense = Carrying value at the beginning of the period $\times$ market (effective) interest rate
2. Calculate cash interest payment = Face value $\times$ stated interest rate
3. The difference between interest expense and the cash payment is the amortization of the discount or premium

With a discount, interest expense is greater than the cash payment, so the carrying value increases each period. With a premium, interest expense is less than the cash payment, so the carrying value decreases each period. Either way, the carrying value converges to face value by maturity.

This method produces a constant effective interest rate but a changing dollar amount of interest expense each period.

Straight-line method of amortization

The straight-line method simply divides the total discount or premium evenly across all periods. For example, a $\$4{,}000$ discount on a 10-period bond means $\$400$ of amortization each period.

This method is simpler but produces a varying effective interest rate from period to period. Under U.S. GAAP, straight-line amortization is acceptable only if the results are not materially different from the effective-interest method. IFRS requires the effective-interest method.

Bonds payable on balance sheet

Bonds payable are reported on the balance sheet as a liability, presented at their carrying value (face value adjusted for any unamortized discount or premium).

As a long-term liability

The non-current portion of bonds payable appears in the long-term liabilities section. It's reported as:

• Face value minus unamortized discount, or
• Face value plus unamortized premium

For example, if a bond has a $\$500{,}000$ face value and a remaining unamortized discount of $\$12{,}000$, the carrying value reported is $\$488{,}000$.

Current portion of bonds payable

If any portion of the bonds matures within the next 12 months (or operating cycle, if longer), that amount is reclassified from long-term liabilities to current liabilities. Any associated unamortized discount or premium is reclassified proportionately along with it.

Interest expense on bonds

Interest expense represents the total cost of borrowing through bonds. It includes both the cash paid to bondholders and the amortization of any discount or premium.

Cash interest payments

Cash interest is calculated as:

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

For a $\$200{,}000$ bond with a 5% annual stated rate paying semi-annually, each cash payment is $\$200{,}000 \times 5\% \times \frac{1}{2} = \$5{,}000$. This amount stays the same every period because it's based on the fixed face value and stated rate.

Amortization of bond discount or premium

• Discount amortization increases interest expense above the cash payment. The discount represents additional borrowing cost because the company received less cash than it must repay.
• Premium amortization decreases interest expense below the cash payment. The premium represents a reduction in borrowing cost because the company received more cash than it must repay.

Under the effective-interest method, the journal entry each period debits Interest Expense for the full calculated amount, credits Cash for the coupon payment, and credits Discount on Bonds Payable (or debits Premium on Bonds Payable) for the difference.

Impact on income statement

Interest expense appears on the income statement as a non-operating expense (often under "Other expenses" or "Finance costs"). It reduces net income and earnings per share. For companies with significant bond debt, interest expense can materially affect reported profitability.

Retirement of bonds payable

Bonds can be retired before maturity through early extinguishment, either by exercising a call provision or by purchasing the bonds on the open market. Any difference between the carrying value and the amount paid results in a gain or loss.

Extinguishment before maturity

When bonds are retired early:

1. Update any accrued interest and amortization through the retirement date
2. Remove the bonds' carrying value from the books (face value plus or minus any remaining unamortized premium or discount)
3. Record the cash paid to retire the bonds (the call price or market purchase price)
4. Recognize any difference as a gain or loss

Gains or losses on extinguishment

• A gain occurs when the retirement price is less than the carrying value (you paid less than the book amount of the debt)
• A loss occurs when the retirement price exceeds the carrying value (you paid more than the book amount)

These gains or losses are reported on the income statement. Under current U.S. GAAP, they're generally presented as a component of income from continuing operations (not as extraordinary items, since that classification was eliminated by ASU 2015-01).

Disclosures for bonds payable

Companies must disclose key information about their bonds payable in the notes to the financial statements. These disclosures help users assess the terms, risks, and financial impact of the debt.

Required disclosures typically include:

• Face value and maturity date of the bonds, indicating the principal owed and when it comes due
• Interest rate and payment dates, including the stated rate and whether payments are annual, semi-annual, etc.
• Collateral pledged, if any, describing the specific assets backing secured bonds
• Convertibility and call features, including conversion prices, call dates, and call prices where applicable
• Aggregate maturities for each of the next five years, which helps users assess upcoming cash flow requirements

Analyzing bonds payable

Financial ratios involving bonds payable provide insight into a company's leverage, solvency, and ability to service its debt. Investors, creditors, and analysts rely on these metrics to assess risk.

Debt-to-equity ratio

$\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}$

This ratio measures the proportion of debt financing relative to equity financing. A higher ratio indicates greater financial leverage, which amplifies both potential returns and risk.

Times interest earned ratio

$\text{Times Interest Earned} = \frac{\text{EBIT}}{\text{Interest Expense}}$

Also called the interest coverage ratio, this measures a company's ability to meet its interest obligations from operating earnings. A ratio of 3.0, for instance, means the company earns three times its interest expense. Higher values suggest a more comfortable margin of safety for debt service.

Credit ratings and their impact

Credit rating agencies (Moody's, Standard & Poor's, Fitch) assign ratings to bond issuers and individual bond issues.

• Investment-grade ratings (BBB-/Baa3 and above) indicate lower credit risk and typically result in lower interest rates on new issuances
• Speculative-grade ratings (BB+/Ba1 and below, sometimes called "junk" bonds) indicate higher credit risk, leading to higher interest rates and more restrictive covenants

Changes in credit ratings can significantly affect a company's borrowing costs and its ability to access debt markets. A downgrade may trigger higher interest rates on variable-rate debt or even accelerate repayment obligations under certain bond covenants.