13.2 Bonds Payable and Debt Issuance
Key Takeaways
- Bond pricing is determined by calculating the present value of the future principal payment and periodic interest payments discounted at the market (effective) interest rate.
- The effective interest method is required under US GAAP, where Interest Expense is calculated as Carrying Value times the Effective Rate, and Cash Paid is Face Value times the Stated Rate.
- Under ASU 2015-03, debt issuance costs are presented as a direct deduction from the carrying value of the bonds payable (similar to a discount) and are amortized as interest expense.
- A premium bond carries a stated rate higher than the market rate, causing it to issue above face value; carrying value decreases toward face value over time.
- A discount bond carries a stated rate lower than the market rate, causing it to issue below face value; carrying value increases toward face value over time.
13.2 Bonds Payable and Debt Issuance
Bond Terminology and Pricing
A bond is a long-term debt contract under which the issuer promises to pay the bondholder periodic interest (coupon payments) and a principal amount (face value or par value) at a specified maturity date.
The cash flows of a bond consist of:
- Periodic interest payments: An annuity of payments calculated as:
Interest Payment = Face Value * Stated (Coupon) Rate / Periods per Year - Principal payment: A single lump sum paid at maturity equal to the Face Value.
Determination of Bond Price
Bonds are priced based on the present value of these future cash flows, discounted using the market (effective) interest rate at the time of issuance.
- PV of Principal:
Face Value * PV of $1 Factor (N, Market Rate) - PV of Interest:
Periodic Cash Payment * PV of Ordinary Annuity Factor (N, Market Rate)
Where $N$ is the total number of interest payment periods, and the discount rate is the market interest rate per period.
Relationships between Coupon Rate and Market Rate
The relationship between the stated rate and the market rate determines the bond's issue price:
- Stated Rate = Market Rate: The bond sells at Par (Face Value).
- Stated Rate < Market Rate: The bond sells at a Discount (below face value) because investors demand a higher yield than the bond's stated coupon.
- Stated Rate > Market Rate: The bond sells at a Premium (above face value) because the bond's coupon is more attractive than the market rate.
Effective Interest Amortization
Under US GAAP, the effective interest method is required to amortize bond discounts and premiums over the life of the bond. The straight-line method is only permitted if its results are not materially different from the effective interest method.
The carrying value of a bond is:
- Discount bond:
Face Value - Unamortized Discount - Premium bond:
Face Value + Unamortized Premium
Steps in the Effective Interest Method
For each interest period:
- Interest Expense:
Carrying Value at Beginning of Period * Market (Effective) Rate per Period - Cash Paid:
Face Value * Stated (Coupon) Rate per Period - Amortization: The difference between Interest Expense and Cash Paid.
- For a discount bond, Interest Expense > Cash Paid. The difference is added to the carrying value (by reducing the unamortized discount).
- For a premium bond, Interest Expense < Cash Paid. The difference is subtracted from the carrying value (by reducing the unamortized premium).
Amortization Table Example
Consider a $100,000, 8% stated rate bond, payable semi-annually on June 30 and December 31, issued on January 1, Year 1, to yield 10%. The bond matures in 5 years ($N=10$ semi-annual periods). The market rate per period is 5%. The cash interest payment is $4,000 per period. The calculated issue price is $92,278.
| Period | Beginning Carrying Value | Interest Expense (5% of CV) | Cash Paid (4% of Face) | Discount Amortization | Ending Carrying Value |
|---|---|---|---|---|---|
| 0 (Jan 1, Yr 1) | — | — | — | — | $92,278 |
| 1 (Jun 30, Yr 1) | $92,278 | $4,614 | $4,000 | $614 | $92,892 |
| 2 (Dec 31, Yr 1) | $92,892 | $4,645 | $4,000 | $645 | $93,537 |
Notice that the carrying value of the discount bond increases each period, moving closer to the $100,000 face value. Consequently, interest expense increases each period because it is calculated on a growing carrying value.
Accounting for Debt Issuance Costs (ASU 2015-03)
ASU 2015-03 governs the treatment of debt issuance costs (e.g., underwriting fees, legal and accounting fees, printing costs, registration fees).
Under this standard:
- Debt issuance costs are not deferred charge assets.
- Instead, they are presented on the balance sheet as a direct deduction from the carrying value of the debt liability, matching the presentation of a bond discount.
- Amortization of debt issuance costs is treated as a component of interest expense over the term of the debt using the effective interest method.
- The inclusion of debt issuance costs increases the effective interest rate of the bond, as the net cash proceeds received are lower.
Journal Entries for Bond Issuance and Amortization
Let's see the entries for a company issuing $1,000,000 face value bonds at a discount of $30,000, and incurring $20,000 of debt issuance costs. Net cash proceeds = $950,000 ($970,000 - $20,000).
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At Issuance:
Debit: Cash $950,000 Debit: Discount on Bonds Payable $50,000 Credit: Bonds Payable $1,000,000Note: The Discount on Bonds Payable account combines both the market discount of $30,000 and the debt issuance costs of $20,000. The carrying value of the bonds at issuance is $950,000 ($1,000,000 face value minus the $50,000 discount).
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First Interest Amortization (Assuming Effective Rate of 6.32% annual, annual interest payment of $50,000): Interest Expense =
$950,000 * 6.32% = $60,040Cash Interest Paid =$1,000,000 * 5% = $50,000Amortization of Discount/Issuance Costs =$60,040 - $50,000 = $10,040Journal Entry:
Debit: Interest Expense $60,040 Credit: Cash $50,000 Credit: Discount on Bonds Payable $10,040
A company issues a 5-year, $500,000 bond with a stated interest rate of 6%, payable semi-annually. The market rate of interest for similar bonds is 8%. The present value of 1 at 4% for 10 periods is 0.6756, and the present value of an ordinary annuity at 4% for 10 periods is 8.1109. What is the issue price of the bond?
On January 1, Year 1, a company issued $1,000,000 face value bonds at a discount, receiving cash proceeds of $950,000. The bonds have a stated rate of 5% payable annually on December 31, and were issued at an effective interest rate of 6%. Under the effective interest method, how much interest expense should the company record on December 31, Year 1?
Under ASU 2015-03, how should a company report debt issuance costs of $30,000 incurred during the issuance of $1,000,000 bonds?
A company issues $2,000,000 of 8% stated rate bonds on January 1, Year 1, for $2,100,000. Interest is paid annually on December 31, and the effective interest rate is 7%. What is the carrying value of the bonds at December 31, Year 1, after the first interest payment?