1. Bonds are issued by businesses as a means of borrowing money from investors. They involve regular interest payments and repayment of the full amount at maturity.
2. Bond buyers earn interest by loaning money to businesses through bond purchases. Bond issuers pay interest for having the use of investors' money.
3. Bonds are priced based on their future cash flows, with discounts for lower stated interest rates and premiums for higher stated rates.
2. EXAMPLE: Assume a $1000 bond is being sold today to yield 12% annual interest and the maturity
date is one and one-half years from today. The bond pays interest semiannually. The stated rate of
interest is 10%.
This means the following:
Face value, maturity value or Par = $1000
The number of time periods, n = 3 (1 ½ years time 2 time periods per year).
Interest rate to use in tables is 6%. (12% / 2 = 6%)
Annuity payment/receipt each six months = cash paid/received = Face value times stated rate times ½ =
$1000 x 10% x ½ = $50
Sales/Purchase price of bond is:
PvAmt = $1000 x .83962 = 839.62 (.83962 is the table factor from using a present value of
amount table where n = 3, I = 6%)
PvAo = $50 x 2.67301 =133.65 (2.67301 is the table factor from using a present value of an
annuity table where n = 3, I = 6%)
Purchase/sales Price will equal the sum of the above two amounts = 839.62 + 133.65 = 973.27
This bond is sold/purchased at a discount as a result of the stated interest rate of 10% being less
that the effective interest rate of 12% annually. The bond is being sold/purchased at 97.327 or 97.327%
of par. A bond that sells at a discount also means the true amount of interest agreed upon by the
issurer/buyer is more than the $150.00 over the life of the bond. ($50.00 paid/received every six months
for 1 ½ years, or a total of $150.00). The true amount of interest over a life of a bond can be determined
by comparing the sum of the maturity value plus all interest payments to the issue/purchase price. In this
case [$1000.00 + 3($50.00)] compared to $973.27; which equals a difference of $176.73. Therefore, the
true amount of interest over the life of the bond is $176.73. This will be recognized in the books of the
issuer/buyer over the three six-month periods using the Revenue Recognition Principle. There are two
different ways the interest may be recognized over the life of the bond. One is the Straight-line method
the other is the Effective Interest method.
The Straight-line method will take the total amount of interest over the life of the bond and divide
by the number of periods to arrive at an equal amount then recognize this amount each period. The
Effective Interest method will use the true interest rate (in this case 12%) and multiply it times the
Carrying Value of the bond (Bond payable minus Discount amount, or Bond payable plus Premium
amount). In this case it would be $1000.00 – $26.73 = $973.27, which you can see is the sales/purchase
price to start with. The Carrying Value changes each period, and therefore, the Effective Interest method
results in a slightly different amount of interest being recognized each period. The Effective Interest
method is required under GAAP. The Straight-line method can be used if it is “not materially different”
than the Effective Interest method.
JOURNAL ENTRIES:
Entry at date of sale/purchase:
Seller/Issuer/Borrower:
Cash 973.27
Discount on bond payable 26.73
Bond payable 1000.00
3. Buyer/Lender/Investor:
Bond investment 973.27
Cash 973.27
OR
Bond investment 1000.00
Discount on bond investment 26.73
Cash 973.27
Entry On Interest Payment Dates – Seller/Issuer/Borrower Only:
Straight-Line Method:
Bond Discount amortization each period would be equal to (1000.00 - 973.27) / 3 = 8.91
First Payment: Second Payment: Third Payment:
Interest expense 58.91 58.91 58.91
Discount on B/P 8.91 8.91 8.91
Cash 50.00 50.00 50.00
Effective Interest Method:
See below for amortization calculations.
First Payment: Second Payment: Third Payment:
Interest expense 58.40 58.90 59.43
Discount on B/P 8.40 8.90 9.43
Cash 50.00 50.00 50.00
Calculation of interest expense and amortization using the Effective Interest method follows:
Carrying value times annual interest rate times time in relation one year equals the interest amount.
Also remember that carrying value changes each period by the amount of discount amortization.
973.27 x 12% x 6/12 = 58.40
981.67 x 12% x 6/12 = 58.90 981.67 = 973.27 + (58.40 - 50.00)
990.57 x 12% x 6/12 = 59.43 990.57 = 981.67 + (58.90 - 50.00)
After the third payment (at the maturity date) the carrying value would be equal to 1,000.00.
(990.57 + 8.91 + 8.91 + 8.91) or (990.57 + 8.40 + 8.90 + 8.93) which means the bond is due to be paid
off/collected. The following entry would be made on the maturity date:
Entry on Maturity Date:
Seller/Issuer/Borrower:
Bond payable 1000.00
Cash 1000.00
Buyer/Lender/Investor:
Cash 1000.00
Bond investment 1000.00
4. If instead of being issued on the interest date the bond was sold/purchased one month after the
first interest date, there would be accrued interest and the entry for buying/selling would be a little
different. Accrued interest = 1000.00 x 12% x 1/12 = 10.00.
Entry at date of sale/purchase:
Seller/Issuer/Borrower:
Cash 983.27
Discount on B/P 26.73
Bond payable 1000.00
Interest payable 10.00
Buyer/Lender/Investor:
Bond investment 973.27
Interest receivable 10.00
Cash 983.27
OR
Bond investment 1000.00
Interest receivable 10.00
Discount on bond 26.73
Cash 983.27
- - - - - - - - - - - - -
Recall from page one, when the stated rate of interest is more than the market rate of interest a
bond would sell for a premium. As a result the interest expense of the seller and the interest revenue of
the buyer would be less than the interest payment - just the opposite of a discount situation.
An entry for a $1,000.00 bond selling at a premium of 5% (i.e., at 105) would be as follows:
Seller/Issuer/Borrower:
Cash 1050.00
Bonds payable 1000.00
Premium on bonds payable 50.00
Buyer/Lender/Investor:
Bond investment 1050.00
Cash 1050.00
OR
Bond investment 1000.00
Premium on bond investment 50.00
Cash 1050.00
Helpful Hint: Use T accounts for all entries to visualize the effects of each entry on the accounts.