Tutorial
Table of Contents 1 Learning Objectives 7 Interest Expense on Bonds Issued at a Discount 2 Overview 8 Amortization of Discount - Straight-line Method 3 Stated and Market Rates 9 Interest Expense on Bonds Issued at a Premium 4 Issuing Bonds at Face Value 10 Amortization of Premium - Straight-line Method 5 Issuing Bonds at a Discount or Premium 11 Summary 6 Review Question 1 12 Key Terms
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Learning Objectives After completing this tutorial you should be able to:
Table of Contents
Overview
A company needing a large amount of money may be unable to get it from one creditor. Bonds are a form of debt where money is borrowed from multiple lenders. Bonds Payable are contracts between an organization and the lenders in which the borrower agrees to repay the amount borrowed at specified dates and to pay specified amounts of interest.Most corporate bonds are paid at the end of the debt's life. The final amount to be paid to the bondholders is called the face value of the bond. The specified date at which this amount is to be paid is called the maturity date. The annual interest paid on the bond is called the stated rate of interest. As an example, assume that Cottell Corporation issues $100,000 of 8%, five-year bonds on January 1, 2000. In this case the face value of $100,000 is paid on January 1, 2005 (maturity date). Interest paid every year is $8,000 (.08 x $100,000). Table of Contents
Stated and Market Rates
As explained on the previous screen, an annual rate of interest is specified for bonds. This interest rate is called the stated rate. The amount of interest paid by the issuer of the bond equals the face value of the bond multiplied by the stated rate. The market rate is the rate that creditors demand for loaning their money. The rate that creditors are willing to accept depends on the level of risk associated with the investment.Bond issuers may decide on a stated rate of interest equal to the rate they expect the market to demand at the time of issue. However, the actual market rate at the time of issue may not be equal to the stated rate. If the two rates are equal the bonds are issued at face value, otherwise the issue price is different from the face value.
Issuing Bonds at Face Value
If the market rate is equal to the stated rate, then the bonds are said to be sold at par (face value). In the previous example, Cottell Corporation issued $100,000 of 8%, five-year bonds on January 1, 2000. If the market rate is 8% and the stated rate is 8%, the bonds are sold for $100,000. The journal entry for the issuance of the bonds is given below: DATE ACCOUNT DEBIT CREDIT 2000 Jan. 1 Cash Bonds Payable 100,000 100,000 Table of Contents
DEBIT
CREDIT
100,000
Issuing Bonds at a Discount or PremiumIf the market rate is higher than the stated rate, then the bonds are issued at a discount. In the previous example, if the market rate is 10% and the stated rate is 8%, investors are not willing to pay the face value because they can get a better rate on other investments of similar risk. The amount by which the face value exceeds the price at which the bonds are sold is called the discount on bonds payable. If the market rate is lower than the stated rate, then the bonds are issued at a premium. In the previous example, if the market rate was 7.5% and the stated rate is 8%, investors are willing to pay more than the face value because the bonds pay more than other investments of similar risk. The amount by which the price at which the bonds are issued exceeds the face value is called the premium on bonds payable.
Review Question 1Fill in the blanks. Use a term from the list given below.
Terms: discount face value higher lower premium stated
discount
face value
higher
lower
premium
stated
The amount by which the face value exceeds the price at which the bonds are sold is called the .
If the amount at which the bonds are sold exceeds the face value the bonds are sold at a .
The annual interest paid on a bond is calculated by multiplying the face value of the bond by the rate of interest.
The amount paid to the bondholders at maturity equals the .
Bonds are sold at a premium when the market rate of interest is than the stated rate.
Bonds are sold at a discount when the market rate of interest is than the stated rate.
Interest Expense on Bonds Issued at a DiscountAssume that a company issues 8-year, 10% bonds for $100,000 at 95 on January 1, 2000. Interest is paid semi-annually on Jan. 1 and Jul. 1. The company pays $10,000 (0.1 x $100,000) interest annually. Each semi-annual interest payment is $5,000 ($10,000 x 1/2). The issue price of the bonds is $95,000 (.95 x $100,000). However, the company pays $100,000 to the bondholders at the end of the eight years. The difference of $5,000 between the face value and the issue price (discount) is also a cost of borrowing money (interest). Thus the total interest cost incurred by the company on the bonds includes the semi-annual interest payments of $5,000 as well as the discount of $5,000.Accrual accounting matches expenses to the revenues earned by incurring those expenses. Rather than allocate the entire discount of $5,000 to interest expense at the time of issuance of the bonds, this difference is temporarily assigned to a Discount on Bonds Payable account. The discount is then systematically allocated to expense. The process of assigning the discount to interest expense is called amortization. The difference between the face value of the bond and the discount is called the carrying value of the bond. As the discount is amortized over the life of the bond, the amount of discount keeps decreasing. Correspondingly, the carrying value of the bond increases over the life of the bond. The carrying value equals face value on the maturity date. This tutorial describes one method of amortization - the straight-line method.Table of Contents
Amortization of Discount - Straight-line Method
The straight-line method allocates equal amounts of the discount to interest expense over each period of the bond's life.Assume that Plymouth Corporation issued $200,000 of 9%, five-year bonds at 99 on January 1, 2000. Interest is paid semi-annually on January 1 and July 1. The fiscal year end is December 31.The stated rate of 9% is the annual rate of interest. Interest paid every year is (0.09 x $200,000).Since interest is paid semi-annually,the amount of interest paid every six months is ( 0.09 x $200,000) x 1/2 = $9,000The bonds are issued at 0.99 x $200,000 = $198,000Discount = face value - issue price = $200,000 - $198,000 = $2,000Discount amortization= $2,000/5 = $400 per year. Since interest expense is recorded twice a year, the amortization recorded every six months is $400/2 = $200.The amount of interest expense recorded semi-annually = $9,000 + $200 =$9,200The carrying value of the bond is calculated by subtracting the discount from the face value of the bond. The table below shows how the discount and the carrying value change over the life of the bond. Discount Amortization - Straight-line Method Interest Expense Amortization of Discount Discount Carrying Value of Bond Jan. 1, 2000 2,000 198,000 Jul. 1, 2000 9,200 200 1,800 198,200 Dec. 31, 2000 9,200 200 1,600 198,400 Jul. 1, 2001 9,200 200 1,400 198,600 Dec. 31, 2001 9,200 200 1,200 198,800 Jul. 1, 2002 9,200 200 1,000 199,000 Dec. 31, 2002 9,200 200 800 199,200 Jul. 1, 2003 9,200 200 600 199,400 Dec. 31, 2003 9,200 200 400 199,600 Jul. 1, 2004 9,200 200 200 199,800 Dec. 31, 2004 9,200 200 0 200,000
Interest Expense on Bonds Issued at a Premium
Assume that Schon Company issues 4-year, 10% bonds for $100,000 at 102. Interest is paid semi-annually on Jan. 1 and Jul. 1. The company pays $10,000 (0.1 x $100,000) interest annually. The fiscal year end is December 31. Each semi-annual interest payment is $5,000 ($10,000 x1/2). The issue price of the bonds is $102,000 (1.02 x $100,000). However, the company pays $100,000 to the bondholders at the end of the eight years. Since the amount paid at maturity is $2,000 lower than the amount obtained from creditors at the time of issue, this difference of $2,000 can be viewed as reduction in the cost of borrowing money (interest). Thus the total interest cost incurred by the company on the bonds equals the total of the semi-annual interest payments of $5,000 minus the premium of $2,000.Accrual accounting matches expenses to the revenues earned by incurring those expenses. Rather than allocate the entire premium of $2,000 to interest expense at the time of issue of the bonds, this difference is temporarily assigned to a Premium on Bonds Payable account. The premium is then systematically allocated to expense. The process of assigning the premium to interest expense is called amortization. The sum of the face value of the bond and the premium is called the carrying value of the bond. As the premium is amortized over the life of the bond, the amount of premium decreases. Correspondingly, the carrying value of the bond decreases over the life of the bond. The carrying value equals face value on the maturity date.
Amortization of Premium- Straight-line MethodThe straight-line method allocates equal amounts of the premium to interest expense over each period of the bond's life.Schon Company issues 4-year, 10% bonds for $100,000 at 102. Interest is paid semi-annually on January 1 and July 1. The fiscal year end is December 31.The stated rate of 10% is the annual rate of interest. Interest paid every year is (0.1 x $100,000).Since interest is paid semi-annually, the amount of interest paid every six months is (0.1 x $100,000) x 1/2 =$5,000The bonds are issued at 1.02 x $100,000 = $102,000Premium = issue price - face value = $102,000 - $100,000 = $2,000Premium amortization= $2,000/4 = $500 per year. Since interest expense is recorded twice a year, the amortization recorded every six months is $500/2 = $250.The amount of interest expense recorded semi-annually = $5,000 - $250 =$4,750.The carrying value of the bond is calculated by adding the premium to the face value of the bond. The table below shows how the premium and the carrying value change over the life of the bond.
Key Terms