What are Bonds Payable?
Bonds payable are long term liabilities and represent amounts owed by a business to a third party. A business will issue bonds payable if it wants to obtain funding from long term investors by way of loans.
The bond payable will stipulate the interest rate and the term to be used, known as the maturity date. At the maturity date the investor will receive repayment of the principal amount invested and interest. Bonds are transferable, and an investor can sell their bond before the maturity date.
In operation, bonds payable are similar to notes payable. A note payable is issued when there is a small loan required from a single lender. A bond payable is issued if the need is for a larger loan requiring multiple investors. In this case, the loan is split into units called bonds, and for each bond a bond payable (note payable) is issued to the investor.
So issuing bonds payable is a way of raising larger amounts of finance from multiple investors.
Types of Bonds Payable
There are numerous different types of bond with different characteristics, a few of these are listed below:
- Secured bond payable – Secured on specific assets of the business.
- Registered bonds payable – Registered to a particular owner
- Bearer bonds – The owner is the bearer (person who has) the bond.
- Sinking fund bonds payable – Regular amounts have to be transferred into an account (sinking fund) to repay the bond at maturity.
- Serial bonds payable – Issued in groups with differing maturity dates.
- Convertible bonds payable – Allow the owner to exchange them in return for shares in a business.
- Callable bond payable – Can be called in by the business and bought back before the maturity date.
- Debenture bonds payable – Not secured on specific assets of the business.
What are Bonds in Accounting?
To a business, a bond payable represents a series of regular interest payments together with a final principal repayment at the maturity date. To an investor, the bond is a series of interest receipts followed by the return of the principal at the maturity date.
An investor should be prepared to pay the present value of the cash flows for the bond (the bond price).
The present value is given by the present value of the principal repayment plus the present value of the regular annuity created by the interest payments.
The amount the investor should be prepared to pay is then given by the following bonds payable formula:
Present value = Principal / (1+i)n + Interest x ((1-1/(1+i)n)/i)
Where i = market interest rate, and n = number of periods.
Bonds Payable Issued at Par
Market interest rate = Bond rate
Suppose for example, the business issued 100,000, 5 year, 10% bonds, with interest payable every 6 months. The total face value (par value) of the bonds payable is 100,000. The interest payable every 6 months for 5 years is 100,000 x 10% x 6 / 12 = 5,000
If the market rate was also 10%, then the investors,using the formula above, would be prepared to pay the present value of the cash flows:
i = 10%/2 every 6 months n = 2 x 5 =10 6 month periods Bond price = Principal / (1+i)n + Interest x ((1-1/(1+i)n)/i) Bond price = 100,000 / (1 + 10%/2)10 + 5,000 x ((1 - 1 / (1 + 10%/2)10) / (10%/2)) Bond price = 100,000
The investors are prepared to pay the face value 100,000 as the bond rate is the same as the market rate.
The bonds payable would be issued at their face (par) value of 100,000, and the journal entry to record this would be as follows.
| Account | Debit | Credit |
|---|---|---|
| Cash | 100,000 | |
| Bonds payable | 100,000 | |
| Total | 100,000 | 100,000 |
Every 6 months the interest on the bonds payable is paid and the following journal is recorded:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Cash | 5,000 | |
| Total | 5,000 | 5,000 |
Finally, at the end of the 5 year term (the maturity date) the bonds payable have to be paid and the following journal completes the transaction.
| Account | Debit | Credit |
|---|---|---|
| Bonds payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Premium on Bonds Payable
Market interest rate < Bond rate
If the market rate was lower than the bond rate, say 8%, then the investors again should be prepared to pay the present value of the cash flows:
i = 8%/2 every 6 months n = 2 x 5 =10 (6 month periods) Bond price = Principal / (1+i)n + Interest x ((1-1/(1+i)n)/i) Bond price = 100,000 / (1 + 8%/2)10 + 5,000 x ((1 - 1 / (1 + 8%/2)10) / (8%/2)) Bond price = 108,111
The investors are prepared to pay 108,111, more than the face value (a premium) as the bond rate is higher than the market rate.
The bonds payable would be issued at a premium value of 108,111, and the journal entry to record this would be as follows.
| Account | Debit | Credit |
|---|---|---|
| Cash | 108,111 | |
| Bonds payable | 100,000 | |
| Premium on bonds payable | 8,111 | |
| Total | 108,111 | 108,111 |
Every 6 months the interest on the bonds payable is paid and the following journal is recorded:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Cash | 5,000 | |
| Total | 5,000 | 5,000 |
In addition, every 6 months the premium on the bonds payable is amortized over the life of the bond, and a credit for this is taken to the interest expense account.
In this example, the useful life is 10 periods and the amortization is 8,111 / 10 = 811 per period.
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 811 | |
| Premium on bonds payable | 811 | |
| Total | 811 | 811 |
The last two journals could be combined to show a net interest expense of 5,000 – 811 = 4,189.
The explanation for this is that the business must pay back 100,000 plus the interest for 10 periods of 50,000, a total of 150,000, but because the bonds were issued at a premium the net cost to them is 150,000 – 108,111 = 41,889 or 4,189 per period.
At the end of the 5 years the entire premium will have been taken to the profit and loss account and the premium on the bonds payable account will be zero.
Finally, at the end of the 5 year term (the maturity date) the bonds payable have to be paid and the following journal completes the transaction.
| Account | Debit | Credit |
|---|---|---|
| Bonds payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Discount on Bonds Payable
Market interest rate > Bond rate
If the market rate was higher than the bond rate, say 12%, then the investors should be prepared to pay the present value of the cash flows:
i = 12%/2 every 6 months n = 2 x 5 =10 (6 month periods) Bond price = Principal / (1+i)n + Interest x ((1-1/(1+i)n)/i) Bond price = 100,000 / (1 + 12%/2)10 + 5,000 x ((1 - 1 / (1 + 12%/2)10) / (12%/2)) Bond price = 92,640
The investors are prepared to pay 92,640, less than the face value (a discount) as the bond rate is lower than the market rate.
The bonds payable would be issued at a discount value of 92,640, and the journal entry to record this would be as follows.
| Account | Debit | Credit |
|---|---|---|
| Cash | 92,640 | |
| Bonds payable | 100,000 | |
| Discount on bonds payable | 7,360 | |
| Total | 92,640 | 92,640 |
In addition, every 6 months the interest on the bonds payable is paid and the following journal is recorded:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Cash | 5,000 | |
| Total | 5,000 | 5,000 |
Every 6 months the discount on the bonds payable is amortized over the life of the bond and a debit taken to the interest expense account.
In this example the useful life is 10 periods and the amortization is 7,360 / 10 = 736 per period.
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 736 | |
| Discount on bonds payable | 736 | |
| Total | 736 | 736 |
The last two journals could be combined to show a total interest expense of 5,000 + 736 = 5,736.
The explanation for this is that the business must pay back 100,000 plus the interest for 10 periods of 50,000 a total of 150,000, but because the bonds were issued at a discount the net cost to them is 150,000 – 92,640 = 57,360 or 5,736 per period.
At the end of the 5 years the entire discount will have been charged to the profit and loss account and the discount on the bonds payable account will be zero.
Finally, at the end of the 5 year term (the maturity date) the bonds payable have to be paid and the following journal completes the transaction.
| Account | Debit | Credit |
|---|---|---|
| Bonds payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Bonds Payable on Balance Sheet
Bonds payable have terms exceeding one year and are classified as long term liabilities in the balance sheet. The portion of the bonds payable which fall due within 12 months of the balance sheet date are be classified as current liabilities.