Liabilities: Accounting for Bonds Payable (Chapter 7 Study Notes)

Liabilities: Accounting for Bonds Payable

Introduction

This chapter focuses on the accounting treatment of bonds payable, a major category of long-term liabilities. Students will learn definitions, terms, pricing, journal entries, and amortization methods for bonds, as well as the process for retiring bonds before maturity.

Learning Objectives

• Explain and account for current liabilities.

• Describe types, features, and pricing of bonds payable.

• Account for bonds payable transactions.

• Calculate and record interest expense and bond amortization.

• Analyze advantages/disadvantages of debt financing.

• Evaluate a company's debt-paying ability.

• Report liabilities on the balance sheet.

Accounting for Bonds Payable

Definition of Bonds Payable

Bonds payable are formal contracts for borrowing large sums of money, typically from the public, with interest paid at regular intervals and principal repaid at maturity.

• Issuer: Entity borrowing funds (e.g., corporation, government).

• Bondholder: Investor lending funds to the issuer.

• Types of bonds: Secured, unsecured, convertible, callable, serial, term bonds.

• Face value (par value): Principal amount repaid at maturity.

Terms of Bonds Payable

• Interest rate: Rate paid to bondholders, usually stated annually.

• Contractual (coupon) rate: Rate printed on the bond certificate, determines periodic interest payments.

• Market rate (yield): Rate investors demand, fluctuates with market conditions.

• Bond price: Quoted as a percentage of face value (e.g., 102 means 102% of face value).

Pricing Bonds Payable

Bonds are priced at the present value of future cash flows (interest and principal), discounted at the market rate.

• Bonds at par: Stated rate = market rate; price = face value.

• Bonds at discount: Stated rate < market rate; price < face value.

• Bonds at premium: Stated rate > market rate; price > face value.

Formula for bond price:

• Present value of interest payments + Present value of principal repayment

$\text{Bond Price} = \sum_{t=1}^{n} \frac{\text{Interest Payment}}{(1 + r)^t} + \frac{\text{Face Value}}{(1 + r)^n}$

Journal Entries for Bonds Payable

• Issuance at par: Debit cash, credit bonds payable.

• Issuance at discount: Debit cash and discount on bonds payable, credit bonds payable.

• Issuance at premium: Debit cash, credit bonds payable and premium on bonds payable.

Amortization of Bond Discounts and Premiums

Bond discounts and premiums are amortized over the life of the bond, affecting interest expense.

• Straight-line method: Equal amount of discount/premium amortized each period.

• Effective interest method: Amortization based on carrying value and market rate.

Key formulas:

• Carrying value (discount): $\text{Carrying Value} = \text{Face Value} - \text{Unamortized Discount}$

• Carrying value (premium): $\text{Carrying Value} = \text{Face Value} + \text{Unamortized Premium}$

• Interest expense (effective method): $\text{Interest Expense} = \text{Carrying Value} \times \text{Market Rate}$

• Interest payment: $\text{Interest Payment} = \text{Face Value} \times \text{Coupon Rate}$

• Discount amortization: $\text{Discount Amortization} = \text{Interest Expense} - \text{Interest Payment}$

• Premium amortization: $\text{Premium Amortization} = \text{Interest Payment} - \text{Interest Expense}$

Amortization Schedules

Amortization schedules track interest payments, discount/premium amortization, and carrying value over time.

Date	Interest Expense	Interest Payment	Discount/Premium Amortization	Carrying Value
12/31/2012	$1,518	$1,000	$518	$87,482
12/31/2013	$1,574	$1,000	$574	$88,056
12/31/2014	$1,641	$1,000	$641	$88,697
12/31/2015	$1,710	$1,000	$710	$89,407
12/31/2016	$1,781	$1,000	$781	$90,188
12/31/2017	$1,854	$1,000	$854	$91,042
12/31/2018	$1,929	$1,000	$929	$91,971
12/31/2019	$2,006	$1,000	$1,006	$92,977
12/31/2020	$2,085	$1,000	$1,085	$94,062
12/31/2021	$2,167	$1,000	$1,167	$95,229

Additional info: Table values inferred from provided schedule; actual values may vary based on bond terms.

Journal Entries for Bond Interest Payments

• At face value: Debit interest expense, credit cash.

• At discount: Debit interest expense, credit cash and discount on bonds payable.

• At premium: Debit interest expense and premium on bonds payable, credit cash.

Retirement of Bonds Payable Before Maturity

Bonds may be retired before maturity by repurchasing them on the open market or calling them at a specified price.

• Early retirement: May result in gain or loss, calculated as the difference between carrying value and retirement price.

• Formula: $\text{Gain/Loss} = \text{Retirement Price} - \text{Carrying Value}$

Summary Table: Bond Features and Pricing

Feature	Description
Face Value	Principal repaid at maturity
Coupon Rate	Stated interest rate on bond
Market Rate	Rate investors demand
Discount	Bond price < face value
Premium	Bond price > face value

Example: Bond Issuance and Amortization

A company issues $100,000 in bonds at a discount. The market rate is higher than the coupon rate. The company records the discount and amortizes it over the bond's life, increasing interest expense each period.

Additional info:

• These notes expand on brief points with academic context, formulas, and examples for clarity.

• Tables are reconstructed and summarized for study purposes.

Return on equity = net income/ total equity

Leverage (Debt Financing) — Notes

What is Financial Leverage?

Financial leverage is when a company uses debt to earn a higher return for shareholders. The idea: 👉 If the return on a project is higher than the interest rate on debt, then ROE goes up.

Why Leverage Matters

• Debt does not increase equity.

• So if a project earns more than it costs to borrow, the profit increases but equity stays the same.

• This boosts ROE (Return on Equity).

ROE= net income/ equity

The Key Relationship

✔ If Project ROI > Interest Rate → Leverage is good

ROE goes up

✘ If Project ROI < Interest Rate → Leverage is bad

ROE goes down

Why Debt Can Increase ROE

• Interest is usually lower than the return the company can earn on projects.

• Even though interest expense reduces income, equity stays the same → higher ROE.

Example from the problem:

• ROI = 15%

• Interest = 12%

• Since 15% > 12%, debt increases ROE (30.3% instead of 30%)

Equity Financing vs Debt Financing

Equity financing:

• Raises equity

• Increases the ROE denominator

• Even if income rises, ROE may decrease

Debt financing:

• Equity stays the same

• Only income is affected

• If ROI > interest → ROE increases

Why Companies Use Leverage

✔ Boost ROE ✔ Keep ownership and control ✔ Benefit when returns exceed borrowing cost

Risks of Leverage

✘ Must pay interest even in bad years ✘ Too much debt increases risk of bankruptcy ✘ High debt makes future borrowing harder

Example: Using Equity vs Borrowing

Background

You run a small business. You want to start a new mini-project that costs $50,000 and will earn $8,000 per year (16% return).

You have two ways to get the $50,000:

Option 1: Issue Equity

You bring in a new investor who gives you $50,000 in exchange for ownership.

Option 2: Borrow Debt

You borrow $50,000 from a bank at 10% interest ($5,000 per year).

Your business currently has:

• Equity: $200,000

• Net income (without project): $40,000

Option 1: Use Equity

New net income:

40,000 + 8,000 = 48,000

New equity:

200,000 + 50,000 = 250,000

ROE:

ROE = 48,000/250,00 = 19.2%

📉 ROE goes down (from 20% to 19.2%) Why? Because equity got bigger when you added a new investor.

Option 2: Borrow the Money

Interest expense:

50,000 × 10% = 5,000

New net income:

40,000 + 8,000 − 5,000 = 43,000

Equity stays the same:

= 200,000

ROE:

43,000/200,000 = 21.5%

📈 ROE goes up (from 20% to 21.5%) Why? Because the project earned 16%, and the interest rate was only 10%.

You earned more than you paid → leverage boosted ROE.