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, 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, a bond payable is similar to notes payable. A business issues a note payable when there is a small loan required from a single lender. The business issues a bond payable if the need is for a larger loan requiring multiple investors. In this case, the business splits the loan into units called bonds, and for each bond a bond payable (note payable) is issued to the investor.
So issuing bonds is a way of raising larger amounts of finance from multiple investors.
Types of Bonds Payable
There are many different types of bond with different characteristics, the list below shows a few of the types available.
- Secured bond payable – Secured on specific assets of the business such as property or equipment.
- 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 – A convertible bond is in effect a normal bond with a call option attached, the owner receives an interest payment (coupon payment) until maturity, and then has the option to convert the bond into shares in the business at a pre-agreed rate.
Due to the call option, a convertible bond tends to have a lower interest rate than a normal bond, thereby reducing interest payments for the issuing business. However, due to its hybrid nature (part equity, part debt), a convertible bond ranks lower than a traditional bond in the event of bankruptcy, and investors who buy convertible bonds therefore have less security and higher risk. The upside to the investor is the potential for gain on conversion of the call option. A convertible bond is sometimes referred to as a convertible note, convertible debenture, or convertible securities.
- Callable bond payable – Can be called in by the business and bought back before the maturity date.
- Puttable bonds payable – A puttable bond is effectively the opposite of a callable bond in that it gives the bondholder the right to decide whether to sell it back early or keep it until it matures.
- 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. The interest is determined by the bond principal and the bond interest rate known as the bond coupon rate.
What is a Bond Coupon Rate?
The bond coupon rate is the interest rate that the issuer pays to the holder of the bond (the investor). The bond coupon rate is normally a fixed rate for the term of the bond and interest is usually paid every six months.
Historically, bonds where issued in paper form with a coupon attached to them representing each interest payment. On the due date the bond holder would remove the coupon and exchange it at the bank for the interest payment. As the interest rate was identified on this coupon it became known as the bond coupon rate.
A zero coupon bond is a bond which does not have coupons and therefore does not make interest payments.
Bond Price
An investor should be prepared to pay the present value of the cash flows from 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 + Principal x Bond rate x ((1-1/(1+i)n)/i)
Where i = market interest rate for a period, Bond rate = interest rate on the bond for a period, and n = number of periods.
It is important to note that there is an inverse relationship between the market interest rate (i) and the bond price. When the market interest rate increases, the bond price decreases and vice versa.
Bonds Payable Issued at Par
Market interest rate equal to 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 bond 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.
Bonds Payable Issued at Par Journal Entry
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 | |
| Bond payable | 100,000 | |
| Total | 100,000 | 100,000 |
Every 6 months the interest on the bonds 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 have to be paid and the following journal completes the transaction.
| Account | Debit | Credit |
|---|---|---|
| Bond payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Premium on Bonds Payable
Market interest rate less than 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.
Bonds Payable Issued at Premium Journal Entry
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 | |
| Bond payable | 100,000 | |
| Premium on bond 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 bond 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 |
|---|---|---|
| Bond payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Discount on Bonds Payable
Market interest rate greater than 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.
Bonds Payable Issued at Discount Journal Entry
The bond 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 | |
| Bond payable | 100,000 | |
| Discount on bond payable | 7,360 | |
| Total | 100,000 | 100,000 |
In addition, every 6 months the interest on the bond 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 bond 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 bond payable has to be paid and the following journal completes the transaction.
| Account | Debit | Credit |
|---|---|---|
| Bond payable | 100,000 | |
| Cash | 100,000 | |
| Total | 100,000 | 100,000 |
Bond Payable on Balance Sheet
Bond payable have terms exceeding one year and are classified as long term liabilities in the balance sheet. The portion of the bond payable which falls due within 12 months of the balance sheet date are classified as current liabilities.
What is the Yield to Maturity?
The yield to maturity (YTM) of a bond is the rate of return a bond will generate for an investor if it is held to its maturity date. The yield to maturity formula takes into account interest payments and capital gains.
Mathematically, to calculate bond yield to maturity, we need to find the internal rate of return (IRR) of the bond if held to its maturity date. What this means is that if we discounted all the cash flows from the bond using the yield to maturity as the discount rate, then the present value of the cash flows would be equal to the price paid for the bond; or to put it another way, the net present value of all cash flows relating to the investment in the bond are zero.
The bonds YTM is also referred to as the redemption yield.
Retirement of Bonds Payable
Retirement of bonds is the process of a business repaying the amount of the bond to the investors. Retirement of bonds normally happens when the bond reaches its maturity date, but can happen at an earlier date if the terms of the bond permit. A premium or a discount may arise on the early retirement of bonds.
For example, a business may issue a 5 year bond on which it will pay interest to the investor. At the end of the 5 year period on the maturity date, the business will need to pay the investor the market price for the bond. After the repayment the bond is retired and no longer exists. If the bond terms stipulated that the business can buy back the bonds at any time (usually at a premium), bond retirement can take place before maturity.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.