Sarah Walcher

Corporations frequently use bonds to fund major capital expenditures, acquisitions, or research and development projects. Issuing bonds allows organizations to raise substantial capital without diluting ownership or seeking direct bank loans. The bond represents a contractual obligation to repay the borrowed funds, making it a liability on the issuer’s balance sheet.

What is Bonds Payable? A 2024 Accounting Guide

In order to calculate bonds payable, it is important to know the par value, the interest rate and maturity date of the bond. Since bonds are financing instruments that represent a future outflow of cash — e.g. the interest expense and principal repayment — bonds payable are considered liabilities. Some bonds require the issuing corporation to deposit money into an account that is restricted for the payment of the bonds’ maturity amount. Also notice that under both methods the total interest expense over the life of the bonds is $48,851 ($45,000 of interest payments plus the $3,851 of bond discount.) Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.

If a governmental entity accounting under GASB issues the bond, the issuance cost will be expensed as incurred on the statement of net activities. The principal portion of the bond is recognized as a bond payable in the liabilities section of the balance sheet. Additionally, if bonds are paid off before their maturity date, the remaining unamortized issuance costs will be expensed as of the payoff date. Bonds will have a stated rate of interest dictating the value of the periodic interest payments.

For example, on September 1, 2021, an investor purchases $100,000, 10-year, 8% bonds, at par, with turbotax online interest payable each May 1 and November 1. For example, if an investor purchases bonds four months after the last interest payment, the issuer will add these additional four months of interest to the purchase price. The bond issuer must, therefore, sell these at a discount to entice investors to purchase them. The stated rate of 8% is less than the market rate of 9%, resulting in a present value less than the face amount of $500,000.

Financial Ratios: Analyzing Bonds Payable’s Impact

• Companies that follow ASPE can choose to use the simpler straight-line interest method.
• This account is a non-operating or “other” expense for the cost of borrowed money or other credit.
• Bonds payable represent a contractual obligation between a bond issuer and a bond purchaser.
• Suppose a company raised $1 million in the form of bond issuances.
• This practice enables investors with less cash to invest to purchase some of the bonds.
• Over the life of the bonds the bond issue costs are amortized to interest expense.

The present value of a bond is calculated by discounting the bond’s future cash payments by the current market interest rate. To illustrate the premium on bonds payable, let’s assume that in early December 2023, a corporation has prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). Present value calculations discount a bond’s fixed cash payments of interest and principal by the market interest rate for the bond. Knowing them is necessary to understand what is bonds payable in accounting and a company’s debt obligations. The issuance and repayment of bonds payable are classified as financing activities on the statement of cash flows. Under the effective interest rate method, periodic interest expense is calculated by multiplying the bond’s carrying value (face value plus unamortized premium or minus unamortized discount) by the market interest rate (yield rate) at the time of issuance.

Accounting Textbooks and Online Resources

For example, an existing bond that promises to pay 9% interest for the next 20 years will become less valuable if market interest rates rise to 10%. A second reason for bonds having a lower cost is that the bond interest paid by the issuing corporation is deductible on its U.S. income tax return, whereas dividends are not tax deductible. For example, a company issues a $100,000 bond at a $2,000 discount.

• Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline.
• This current liability account reports the amount of interest the company owes as of the date of the balance sheet.
• For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• When a corporation is preparing a bond to be issued/sold to investors, it may have to anticipate the interest rate to appear on the face of the bond and in its legal contract.
• The corporation is receiving the $750 because the corporation is required to pay the bondholders $4,500 ($100,000 x 9% x 6/12) on June 30.

It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. The income statement, statement of cash flows, statement of comprehensive income, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month. The balance sheet reports information as of a date (a point in time). This account is a non-operating or “other” expense for the cost of borrowed money or other credit.

The bonds payable account typically appears within the long-term liabilities section of the balance sheet, since bonds typically mature in more than one year. Essentially, the higher the rating (AAA or investment-grade bonds), the more access the company has to investors’ capital at a reasonable interest rate. If the stated rate is higher, the bond issuance is more desirable, and the investors would be willing to pay more for this investment than for another with a lower stated rate. If the stated rate is more than the market rate, the bond trades at a premium. Straight-line amortization results in varying interest rates throughout the life of the bonds because of the equal amount of the discount applied at each interest payment date. To illustrate, on May 1, 2021, Engels Ltd. issued 10-year, 8%, $500,000 par value bonds with interest payable each year on May 1 and November 1.

The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. Since investors will be receiving $500 less every six months than the market is requiring, the investors will not pay the full $100,000 of a bond’s face value. The first step in calculating the bond’s present value is to calculate the present value of the bond’s interest payments. We calculate these two present values by discounting the future cash amounts by the market interest rate per semiannual period. By the time the bond is offered to investors on January 1, 2024 the market interest rate has increased to 10%.

You’ll receive lifetime access to all of our premium materials and features. If they mature within one year, then the line item instead appears within the current liabilities section of the balance sheet. At the end of Year 2, $800 of the discount has been amortized. The discount is amortized evenly over five years.

Straight-Line Amortization of Bond Discount on Annual Financial Statements

In other words, if the bonds are a long-term liability, both Bonds Payable and Premium on Bonds Payable will be reported on the balance sheet as long-term liabilities. Let’s assume that this 9% bond being issued in an 8% market will sell for $104,100 plus $0 accrued interest. Let’s assume that just prior to selling the bond on January 1, the market interest rate for this bond drops to 8%. This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12). The bond’s interest payment dates are June 30 and December 31 of each year. If the investors are willing to accept the 9% interest rate, the bond will sell for its face value.

Promissory notes, debenture bonds, and foreign bonds are shown with their amounts, maturity dates, and interest rates. This practice enables investors with less cash to invest to purchase some of the bonds. However, though many are listed on exchanges, the vast majority of corporate bonds in developed markets are traded in decentralized, dealer-based, over-the-counter markets. Corporate bonds are often listed on major exchanges (and known as listed bonds) and ECNs, and the coupon (i.e., the interest https://tax-tips.org/turbotax-online/ payment) is usually taxable. A corporate bond is issued by a corporation seeking to raise money in order to expand the business. Intermediate Accounting texts typically devote significant chapters to liabilities, including comprehensive coverage of bonds payable.

The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. This means that when a bond’s book value decreases, the amount of interest expense will decrease.

As we had seen, the market value of an existing bond will move in the opposite direction of the change in market interest rates. Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable. As a result, bond investors will demand to earn higher interest rates.

As discussed, organizations can obtain cash in ways other than a conventional loan, and it is important to understand the options and their benefits. The recorded interest expense is less than the statement amount as a result of the premium amortization. The discount amortization will increase the total amount of interest expense recorded on the income statement. In this situation, investors earn a larger return on their investment because of the purchase at a reduced price.

Because bonds promise future cash flows (interest payments and principal repayment), their value today is the present value of those future cash flows. The initial measurement of a bond payable is at its fair value, typically the amount of cash received from investors. When a corporation or government entity requires capital, it may issue bonds to the public, promising to repay the principal amount at a specified future date, along with periodic interest payments. These financial instruments, governed by accounting standards such as those established by the Financial Accounting Standards Board (FASB), reflect a long-term liability on a company’s balance sheet.