Bonds Payable: In-Depth Explanation with Examples

Introduction

• Bonds as long-term debt (IOU issued by a corporation to investors)
• Obligations of the issuing corporation:
  • Pay interest every six months (stated interest rate)
  • Pay principal or face amount at maturity
• Advantages of issuing bonds over common stock:
  • No dilution of stockholders' ownership
  • Lower cost due to tax deductibility of bond interest

Market Value of Bonds

• Fluctuates with:
  • Market interest rates
  • Financial condition of issuing corporation
• Present value calculations are used to determine market value and effective interest rate

Bond Interest and Principal Payments

Bond Interest Payments

• Paid semiannually
• Formula: Face Amount x Stated Annual Interest Rate x 6/12
• Synonyms for stated interest rate: face, nominal, coupon, contractual

Bond Principal Payment

• Amount on the bond's face
• Synonyms: face value, par, maturity value, stated value

Timeline for Payments

• Example: 9%, $100,000 bond maturing in 5 years
• Total semiannual payments: 10, each $4,500
• Principal payment at maturity

Accrued Interest

• Interest accrues daily
• Monthly reporting requires adjusting entries
• Example: Daily interest on 9% $100,000 bond = $24.66
• Buyer compensates seller for accrued interest during sale

Bonds Issued at Par

Without Accrued Interest

• Issued on the bond's date
• Example: 9%, $100,000 bond issued for $100,000

With Accrued Interest

• Issued after the bond's date, accrued interest added
• Example journal entries for issuance and interest expense

Market Interest Rates and Bond Prices

• Interest Rate Changes:
  • Increase in rates leads to decrease in bond value
  • Decrease in rates leads to increase in bond value
• Investor and Issuer Strategies:
  • Issue bonds before rates rise
  • Buy bonds before rates fall
  • Sell bonds before rates rise

Bond Premium with Straight-Line Amortization

• Occurs when bonds sell above face value (market rate < bond rate)
• Premium recorded as liability, amortized over bond's life

Amortization Methods

• Straight-Line: Equal reduction over bond's life
• Effective Interest Rate Method: Matches interest expense to book value

Bond Discount with Straight-Line Amortization

• Occurs when bonds sell below face value (market rate > bond rate)
• Discount treated as additional interest expense, amortized over bond's life

Calculating Present Value of Bonds

• Present Value (PV) Components:
  • Interest payments (ordinary annuity)
  • Principal payment at maturity
• Use market interest rate for discounting

Amortizing Bond Premium and Discount

Effective Interest Rate Method

• Matches interest expense to book value changes
• Preferred method due to correlation of expense with bond value

Additional Bond Terminologies

• Types of Bonds:
  • Term bonds (single maturity date)
  • Serial bonds (mature over time)
  • Secured bonds (collateralized)
  • Unsecured bonds or debentures
  • Convertible bonds
  • Callable bonds
• Bond Sinking Fund: Restricted account for maturity payments
• Issue Costs: Recorded and amortized over bond's life
• Basis Points: 1/100th of a percentage point

Where to Go From Here

• Practice quizzes and further materials available
• Recommendation to join PRO Plus for more resources

Disclaimer

• Materials as introductory; consult professionals for detailed advice