Skip to Content
OpenStax Logo
Principles of Accounting, Volume 1: Financial Accounting

13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds

Principles of Accounting, Volume 1: Financial Accounting13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
Buy book
  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

Recall from the discussion in Explain the Pricing of Long-Term Liabilities that one way businesses can generate long-term financing is by borrowing from lenders.

In this section, we will explore the journal entries related to bonds. Earlier, we found that cash flows related to a bond include the following:

  1. The receipt of cash when the bond is issued
  2. Payment of interest each period
  3. Repayment of the bond at maturity

A journal entry must be made for each of these transactions. As we go through the journal entries, it is important to understand that we are analyzing the accounting transactions from the perspective of the issuer of the bond. These are considered long-term liabilities. The investor would make the opposite journal entries. For example, on the issue date of a bond, the borrower receives cash while the lender pays cash.

A final point to consider relates to accounting for the interest costs on the bond. Recall that the bond indenture specifies how much interest the borrower will pay with each periodic payment based on the stated rate of interest. The periodic interest payments to the buyer (investor) will be the same over the course of the bond. It may help to think of personal loan examples. For example, if you or your family have ever borrowed money from a bank for a car or home, the payments are typically the same each month. The interest payments will be the same because of the rate stipulated in the bond indenture, regardless of what the market rate does. The amount of interest cost that we will recognize in the journal entries, however, will change over the course of the bond term, assuming that we are using the effective interest.

IFRS Connection

Defining Long-Term Liabilities

Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of accounting standards. With two exceptions, bonds payable are primarily the same under the two sets of standards.

The first difference pertains to the method of interest amortization. Beyond FASB’s preferred method of interest amortization discussed here, there is another method, the straight-line method. This method is permitted under US GAAP if the results produced by its use would not be materially different than if the effective-interest method were used. IFRS does not permit straight-line amortization and only allows the effective-interest method.

The second difference pertains to how the bonds are reported on the books. Under US GAAP, bonds are recorded at face value and the premium or discount is recorded in a separate account. IFRS does not use “premium” or “discount” accounts. Instead, under IFRS, the carrying value of bonds issued at either a premium or discount is shown on the balance sheet at its net. For example, $100,000 bonds issued at a discount of $4,000 would be recorded under US GAAP as

Journal entry: debit cash 94,000, debit Discount on Bonds Payabl 6,000, credit Bonds Payable 100,000.

Under IFRS, these bonds would be reported as

Journal entry: debit Cash and credit Bonds Payable each for 94,000.

Obviously, the above example implies that, in the subsequent entries to recognize interest expense, under IFRS, the Bonds Payable account is amortized directly for the increase or reduction in bond principal. Suppose in this example that the cash interest was $200 and the interest expense for the first interest period was $250. The entry to record the transaction under the two different standards would be as follows:

Under US GAAP:

Journal entry: Debit Bond Interest Expense 250, credit Discount on Bonds Payable 50, and Credit Cash 200.

Under IFRS:

Journal entry: Debit Bond Interest Expense 250, credit Bonds Payable 50, and Credit Cash 200.

Note that under either method, the interest expense and the carrying value of the bonds stays the same.

Issuance of Bonds

Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination of the specific characteristics of a bond issue and the actual issuance of the bond. Before the bonds can be issued, the underwriters perform many time-consuming tasks, including setting the bond interest rate. The bond interest rate is influenced by specific factors relating to the company, such as existing debt balances and the ability of the company to repay the funds, as well as the market rate, which is influenced by many external economic factors.

Because of the time lag caused by underwriting, it is not unusual for the market rate of the bond to be different from the stated interest rate. The difference in the stated rate and the market rate determine the accounting treatment of the transactions involving bonds. When the bond is issued at par, the accounting treatment is simplest. It becomes more complicated when the stated rate and the market rate differ.

Issued When Market Rate Equals Contract Rate

First, we will explore the case when the stated interest rate is equal to the market interest rate when the bonds are issued.

Returning to our example of a $1,000, 5-year bond with a stated interest rate of 5%, at issuance, the market rate was 5% and the sales price was quoted at 100, which means the seller of the bond will receive (and the investor will pay) 100% of the $1,000 face value of the bond. The journal entry to record the sale of 100 of these bonds is:

Journal entry: debit Cash and credit Bonds Payable 100,000 each. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 5 percent.”

Since the book value is equal to the amount that will be owed in the future, no other account is included in the journal entry.

Assets equals Liabilities plus Equity; T account for Cash showing 100,000 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side. Balance Sheet Presentation is Bonds Payable $100,000

Issued at a Premium

If, during the timeframe of establishing the bond stated rate and issuing the bonds, the market rate drops below the stated interest, the bonds would become more valuable. In other words, the investors will earn a higher rate on these bonds than if the investors purchased similar bonds elsewhere in the market. Naturally, investors would want to purchase these bonds and earn a higher interest rate. The increased demand drives up the bond price to a point where investors earn the same interest as similar bonds. Earlier, we found that the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% is 104.46. That is, the bond will sell at 104.46% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $1,044.60.

Selling 100 of these bonds, would yield $104,460.

Journal entry: debit Cash 104,460, credit Premium on Bonds Payable 4,460, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 4 percent.”

The financial statement presentation looks like this:

Balance Sheet Presentation: Bonds Payable 100,000, Plus: Premium on Bonds Payable 4,460, equals Carrying (Book) Value $104,460.

On the date that the bonds were issued, the company received cash of $104,460.00 but agreed to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. The difference in the amount received and the amount owed is called the premium. Since they promised to pay 5% while similar bonds earn 4%, the company received more cash up front. In other words, they sold the bond at a premium. They did this because the cost of the premium plus the 5% interest on the face value is mathematically the same as receiving the face value but paying 4% interest. The interest rate was effectively the same.

The premium on bonds payable account is a contra liability account. It is contra because it increases the amount of the Bonds Payable liability account. It is “married” to the Bonds Payable account on the balance sheet. If one of the accounts appears, both must appear. The Premium will disappear over time as it is amortized, but it will decrease the interest expense, which we will see in subsequent journal entries.

Taken together, the Bond Payable liability of $100,000 and the Premium on Bond Payable contra liability of $4,460 show the bond’s carrying value or book value—the value that assets or liabilities are recorded at in the company’s financial statements.

The effect on the accounting equation looks like this:

Assets equals Liabilites plus Equity; T account for Cash showing 104,460 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side and Premium on Bonds Payable T account showing 4,460 on the credit side.

It looks like the issuer will have to pay back $104,460, but this is not quite true. If the bonds were to be paid off today, the full $104,460 would have to be paid back. But as time passes, the Premium account is amortized until it is zero. The bondholders have bonds that say the issuer will pay them $100,000, so that is all that is owed at maturity. The premium will disappear over time and will reduce the amount of interest incurred.

Issued at a Discount

Bonds issued at a discount are the exact opposite in concept as bonds issued at a premium. If, during the timeframe of establishing the bond stated rate and issuing the bonds, the market rate rises above the stated interest on the bonds, the bonds become less valuable because investors can earn a higher rate of interest on other similar bonds. In other words, the investors will earn a lower rate on these bonds than if the investors purchased similar bonds elsewhere in the market. Naturally, investors would not want to purchase these bonds and earn a lower interest rate than could be earned elsewhere. The decreased demand drives down the bond price to a point where investors earn the same interest for similar bonds. Earlier, we found the sale price of a $1,000, 5-year bond with a stated interest rate of 5% and a market rate of 7% is 91.80. That is, the bond will sell at 91.80% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $918.00. On selling 100 of the $1,000 bonds today, the journal entry would be:

Journal entry: debit Cash 91,800, debit Discount on Bonds Payable 8,200, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 7 percent.” Balance Sheet Presentation: Bonds Payable 100,000, Less: Discount on Bonds Payable 8,200, equals Carrying (Book) Value $91,800.

Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. The difference in the amount received and the amount owed is called the discount. Since they promised to pay 5% while similar bonds earn 7%, the company, accepted less cash up front. In other words, they sold the bond at a discount. They did this because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value but paying 7% interest. The interest rate was effectively the same.

Like the Premium on Bonds Payable account, the discount on bonds payable account is a contra liability account and is “married” to the Bonds Payable account on the balance sheet. The Discount will disappear over time as it is amortized, but it will increase the interest expense, which we will see in subsequent journal entries.

The effect on the accounting equation looks like this:

Assets equals Liabilites plus Equity; T account for Cash showing 91,800 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side and Discount on Bonds Payable T account showing 8,200 on the debit side.

First and Second Semiannual Interest Payment

When a company issues bonds, they make a promise to pay interest annually or sometimes more often. If the interest is paid annually, the journal entry is made on the last day of the bond’s year. If interest was promised semiannually, entries are made twice a year.

Concepts In Practice

Municipal Bonds

Municipal bonds are a specific type of bonds that are issued by governmental entities such as towns and school districts. These bonds are issued in order to finance specific projects (such as water treatment plants and school building construction) that require a large investment of cash. The primary benefit to the issuing entity (i.e., the town or school district) is that cash can be obtained more quickly than, for example, collecting taxes and fees over a long period of time. This allows the project to be completed sooner, which is a benefit to the community.

Municipal bonds, like other bonds, pay periodic interest based on the stated interest rate and the face value at the end of the bond term. However, corporate bonds often pay a higher rate of interest than municipal bonds. Despite the lower interest rate, one benefit of municipal bonds relates to the tax treatment of the periodic interest payments for investors. With corporate bonds, the periodic interest payments are considered taxable income to the investor. For example, if an investor receives $1,000 of interest and is in the 25% tax bracket, the investor will have to pay $250 of taxes on the interest, leaving the investor with an after-tax payment of $750. With municipal bonds, interest payments are exempt from federal tax. So the same investor receiving $1,000 of interest from a municipal bond would pay no income tax on the interest income. This tax-exempt status of municipal bonds allows the entity to attract investors and fund projects more easily.

Interest Payment: Issued When Market Rate Equals Contract Rate

Recall that the Balance Sheet presentation of the bond when the market rate equals the stated rate is as follows:

Balance Sheet Presentation is Bonds Payable $100,000.

In this example, the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated interest rate of 5% when the market rate was 5% and received $100,000. As previously discussed, since the bonds were sold when the market rate equals the stated rate, the carrying value of the bonds is $100,000. These bonds did not specify when interest was paid, so we can assume that it is an annual payment. If the bonds were issued on January 1, the company would pay interest on December 31 and the journal entry would be:

Journal entry: debit Interest Expense (0.05 times $100,000) and credit Cash for 5,000 each. Explanation: “To record interest expense on 5 percent bonds sold with effective interest rate of 5 percent.”

The interest expense is calculated by taking the Carrying Value ($100,000) multiplied by the market interest rate (5%). The stated rate is used when calculating the interest cash payment. The company is obligated by the bond indenture to pay 5% per year based on the face value of the bond. When the situation changes and the bond is sold at a discount or premium, it is easy to get confused and incorrectly use the market rate here. Since the market rate and the stated rate are the same in this example, we do not have to worry about any differences between the amount of interest expense and the cash paid to bondholders. This journal entry will be made every year for the 5-year life of the bond.

When performing these calculations, the rate is adjusted for more frequent interest payments. If the company had issued 5% bonds that paid interest semiannually, interest payments would be made twice a year, but each interest payment would only be half an annual interest payment. Earning interest for a full year at 5% annually is the equivalent of receiving half of that amount each six months. So, for semiannual payments, we would divide 5% by 2 and pay 2.5% every six months.

Concepts In Practice

Mortgage Debt

According to Statista the amount of mortgage debt—debt incurred to purchase homes—in the United States was $14.9 trillion on 2017. This value does not include the interest cost—the cost of borrowing—related to the debt.

A common loan term for those borrowing money to buy a house is 30 years. Each month, the borrower must make payments on the loan, which would add up to 360 payments for a 30-year loan. Recall from previous discussions on amortization that each payment can be divided into two components: the interest expense and the amount that is applied to reduce the principal.

In order to calculate the amount of interest and principal reduction for each payment, banks and borrowers often use amortization tables. While amortization tables are easily created in Microsoft Excel or other spreadsheet applications, there are many websites that have easy-to-use amortization tables. The popular lending website Zillow has a loan calculator to calculate the monthly payments of a loan as well as an amortization table that shows how much interest and principal reduction is applied for each payment.

For example, borrowing $200,000 for 30 years at an interest rate of 5% would require the borrow to repay a total $386,513. The monthly payment on this loan is $1,073.64. This amount represents the $200,000 borrowed and $186,513 of interest cost. If the borrower chose a 15-year loan, the total payments drops significantly to $266,757, but the monthly payments increase to $1,581.59.

Because interest is calculated based on the outstanding loan balance, the amount of interest paid in the first payment is much more than the amount of interest in the final payment. The pie charts below show the amount of the $1,073.64 payment allocated to interest and loan reduction for the first and final payments, respectively, on the 30-year loan.

Two pie charts showing the first and final payments on a 30-year loan. The pie chart on the left shows the first payment. A little over three quarters of the chart is “Interest” and the rest is “Principal.” The pie chart on the right shows the final payment. The majority of the chart is “Principal” and a very small portion is “Interest.”

Interest Payment: Issued at a Premium

Recall that the Balance Sheet presentation of the bond when the market rate at issue is lower than the stated rate is as follows:

Balance Sheet Presentation: Bonds Payable 100,000, Plus: Premium on Bonds Payable 4,460, equals Carrying (Book) Value $104,460.

In this scenario, the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% was $1,044.60. If the company sold 100 of these bonds, it would receive $104,460 and the journal entry would be:

Journal entry: debit Cash 104,460, credit Premium on Bonds Payable 4,460, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 4 percent.”

Again, let’s assume that the bonds pay interest annually. At the end of the bond’s year, we would record the interest expense:

Journal entry: debit Interest Expense (0.04 times $104,460) 4,178, debit Premium on Bonds Payable (Difference) 822, and credit Cash for 5,000. Explanation: “To record payment of interest on bonds payable and amortization of premium.”

The interest expense determination is calculated using the effective interest amortization interest method. Under the effective-interest method, the interest expense is calculated by taking the Carrying (or Book) Value ($104,460) multiplied by the market interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate.

Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense and the cash paid to bondholders. The amount of the premium amortization is simply the difference between the interest expense and the cash payment. Another way to think about amortization is to understand that, with each cash payment, we need to reduce the amount carried on the books in the Bond Premium account. Since we originally credited Bond Premium when the bonds were issued, we need to debit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received more for the bonds than face value, but it is only paying interest on $100,000.

The partial effect of the first period’s interest payment on the company’s accounting equation in year one is:

Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 104,460 on the debit side, 5,000 on the credit side and a debit balance of 99,460 equals T account for Bonds Payable showing 100,000 on the credit side plus the Premium on Bonds Payable T account showing 4,460 on the credit side, 822 on the debit side and a 3,638 balance minus the Interest Expense T account with 5,000 on the debit side and 822 on the credit side with a 4,178 debit balance.

And the financial-statement presentation at the end of year 1 is:

Balance Sheet Presentation: Bonds Payable 100,000, plus Premium on Bonds Payable 3,638, equals Carrying (Book) Value $103,638. Income Statement Presentation; Bonds Interest Expense $4,178.

The journal entry for year 2 is:

Journal entry: debit Interest Expense (0.04 times $103,638) 4,146, debit Premium on Bonds Payable (Difference) 854, and credit Cash for 5,000. Explanation: “To record payment of interest on bonds payable and to amortization the bond premium.”

The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate (5%). Since the market rate and the stated rate are different, we again need to account for the difference between the amount of interest expense and the cash paid to bondholders.

The partial effect on the accounting equation in year two is:

Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 104,460 on the debit side, two 5,000 entries on the credit side and a debit balance of 94,460 equals T account for Bonds Payable showing 100,000 on the credit side plus the Premium on Bonds Payable T account showing 3,638 on the credit side, 854 on the debit side and a 2,784 balance minus the Interest Expense T account with two 5,000’s on the debit side and 822 and 854 on the credit side with a 8,324 debit balance.

And the financial-statement presentation at the end of year 2 is:

Balance Sheet Presentation: Bonds Payable 100,000, plus Premium on Bonds Payable 2,784, equals Carrying (Book) Value $102,784. Income Statement Presentation: Bonds Interest Expense $4,146.

By the end of the 5th year, the bond premium will be zero, and the company will only owe the Bonds Payable amount of $100,000.

Interest Payment: Issued at a Discount

Recall that the Balance Sheet presentation of the bond when the market rate at issue was higher than the stated rate is as follows:

Balance Sheet Presentation: Bonds Payable 100,000, minus Discount on Bonds Payable (8,200), equals Carrying (Book) Value $91,800.

We found the sale price of a $1,000, 5-year bond with a stated interest rate of 5% and a market rate of 7% was $918.00. We then showed the journal entry to record sale of 100 bonds:

Journal entry: debit Cash 91,800, debit Discount on Bonds Payable 8,200, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 7 percent.”

At the end of the bond’s first year, we make this journal entry:

Journal entry: debit Interest Expense (0.07 times $91,800) 6,426, credit Cash for 5,000 (0.05 times $100,000), and credit Disount on Bonds Payable (difference) 1,426. Explanation: “To record payment of interest on bonds payable and amortize the discount.”

The interest expense is calculated by taking the Carrying Value ($91,800) multiplied by the market interest rate (7%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) and multiplying it by the stated rate (5%). Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense and the cash paid to bondholders. The amount of the discount amortization is simply the difference between the interest expense and the cash payment. Since we originally debited Bond Discount when the bonds were issued, we need to credit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received less for the bonds than face value but is paying interest on the $100,000.

The partial effect on the accounting equation in year one is:

Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 91,800 on the debit side, 5,000 on the credit side and a debit balance of 86,800 equals T account for Bonds Payable showing 100,000 on the credit side less the Discount on Bonds Payable T account showing 8,200 on the debit side, 1,426 on the credit side and a 6,774 debit balance minus the Interest Expense T account with 5,000 on the debit side and 1,426 on the debit side with a 6,426 debit balance.

And the financial-statement presentation at the end of year 1 is:

Balance Sheet Presentation: Bonds Payable 100,000, minus Discount on Bonds Payable 6,774, equals Carrying (Book) Value $93,226. Income Statement Presentation: Bonds Interest Expense $6,426.

The journal entry for year 2 is:

Journal entry: debit Interest Expense (0.07 times $93,226) 6,526, credit Cash for 5,000 (0.05 times $100,000), and credit Disount on Bonds Payable (difference) 1,526. Explanation: “To record payment of interest on bonds payable and amortize the discount.”

The interest expense is calculated by taking the Carrying Value ($93,226) multiplied by the market interest rate (7%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate (5%). Again, we need to account for the difference between the amount of interest expense and the cash paid to bondholders by crediting the Bond Discount account.

The partial effect on the accounting equation in year two is:

Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 5,000 on the credit side equals T account for Bonds Payable showing 100,000 on the credit side less the Discount on Bonds Payable T account showing 6,774 on the debit side, 1,526 on the credit side, and a 5,248 debit balance minus the Interest Expense T account with 5,000 and 1,526 on the debit side with a 6,526 debit balance.

And the financial statement presentation at the end of year 2 is:

Balance Sheet Presentation: Bonds Payable 100,000, Less: Discount on Bonds Payable 5,248, equals Carrying (Book) Value $94,752. Income Statement Presentation: Bonds Interest Expense $6,526.

By the end of the 5th year, the bond premium will be zero and the company will only owe the Bonds Payable amount of $100,000.

Retirement of Bonds When the Bonds Were Issued at Par

At some point, a company will need to record bond retirement, when the company pays the obligation. Often, they will retire bonds when they mature. For example, earlier we demonstrated the issuance of a five-year bond, along with its first two interest payments. If we had carried out recording all five interest payments, the next step would have been the maturity and retirement of the bond. At this stage, the bond issuer would pay the maturity value of the bond to the owner of the bond, whether that is the original owner or a secondary investor.

This example demonstrates the least complicated method of a bond issuance and retirement at maturity. There are other possibilities that can be much more complicated and beyond the scope of this course. For example, a bond might be callable by the issuing company, in which the company may pay a call premium paid to the current owner of the bond. Also, a bond might be called while there is still a premium or discount on the bond, and that can complicate the retirement process. Situations like these will be addressed in later accounting courses.

To continue with our example, assume that the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated interest rate of 5% when the market rate was 5% and received $100,000. It was recorded in this way:

Journal entry: debit Cash and credit Bonds Payable 100,000 each. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 5 percent.”

At the end of 5 years, the company will retire the bonds by paying the amount owed. To record this action, the company would debit Bonds Payable and credit Cash. Remember that the bond payable retirement debit entry will always be the face amount of the bonds since, when the bond matures, any discount or premium will have been completely amortized.

Journal entry: debit Bonds Payable and credit Cash 100,000 each. Explanation: “ To record the retirement of bonds payable.”
Citation/Attribution

Want to cite, share, or modify this book? This book is Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 and you must attribute OpenStax.

Attribution information
  • If you are redistributing all or part of this book in a print format, then you must include on every physical page the following attribution:
    Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters
  • If you are redistributing all or part of this book in a digital format, then you must include on every digital page view the following attribution:
    Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters
Citation information

© Apr 11, 2019 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 license. The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.