Long-Term Liabilities: Bonds Payable

Long-Term Liabilities: Bonds Payable

Definition of Long-Term Debt

• Long-term debt = probable future sacrifices of economic benefits due to present obligations not payable within one year or the operating cycle, whichever is longer.
• Examples of long-term debt:
  • Bonds payable
  • Long-term notes payable
  • Mortgages payable
  • Lease liabilities
• Associated with covenants or restrictions.

Issuing Bonds

• A bond contract is known as a bond indenture.
• Bonds represent a promise to pay:
  • Principal at maturity
  • Periodic interest at a specified rate (stated rate)
• Typical bond certificate face value = $1,000.
• Interest payments are usually made semiannually.
• Used for raising large capital sums from multiple lenders/investors.

Overview of Bonds Payable

• Multiple lenders loan various amounts in $1,000 increments to a company.
• Example: total loans $2 million from various lenders.

Types of Bonds

• By Nature of Security:
  • Secured bonds: Backed by collateral (e.g., mortgage bonds).
  • Unsecured bonds (debenture bonds): Not backed by collateral, based purely on credit.
• By Maturity Pattern:
  • Term bonds: One maturity date at the end.
  • Serial bonds: Stated amounts mature at regular intervals.
• By Redemption Provisions:
  • Callable bonds: Issuer can repurchase early at a specified price.
  • Convertible bonds: May convert to equity at the holder's option.
• By Valuation:
  • Deep-discount bonds: Sold at a discount to their face value.
  • Commodity-backed bonds: Payable at prices related to a commodity (e.g., gold).
• By Repayment Provisions:
  • Income bonds: Pay interest only if profitable.
  • Revenue bonds: Issued by governments, interest paid from specific revenues.

Issuance and Marketing of Bonds

• Issuing bonds involves a process lasting** weeks or months**.

Interest Rates in Bond Markets

• Stated Rate (Coupon Rate): Interest rate as per bond indenture set by the issuer.
• Yield (Market Rate): Prevailing interest rate for similar bonds, determines what bondholders earn.

Market Pricing of Bonds

• Influenced by:
  • Expected Inflation: Higher expected inflation increases demanded interest rates.
  • Credit Rating: Higher ratings lead to lower return demands relative to peers.
• Relationship with Stated Rate:
  • If the market rate > stated rate, bonds sell at a discount.
  • If the market rate < stated rate, bonds sell at a premium.

Bond Pricing Example

• Stated Rate vs Market Rate:
  • Market < Stated: sell at premium.
  • Market = Stated: sells at par value.
  • Market > Stated: sell at discount.

Accounting for Bonds Payable

• Journal Entries on Issuance:
  • Issued at Par:
  • Dr. Cash
  • Cr. Bonds Payable
  • Issued at Discount:
  • Dr. Cash
  • Dr. Discount on Bonds Payable
  • Cr. Bonds Payable
  • Issued at Premium:
  • Dr. Cash
  • Cr. Premium on Bonds Payable
  • Cr. Bonds Payable
• Journal Entries for Interest:
  • Par:
  • Dr. Interest Expense
  • Cr. Interest Payable or Cash
  • Discount:
  • Dr. Interest Expense
  • Cr. Discount on Bonds Payable
  • Cr. Interest Payable or Cash
  • Premium:
  • Dr. Interest Expense
  • Dr. Premium on Bonds Payable
  • Cr. Interest Payable or Cash

Summary Points

• Bond Pricing: Determined by present value of interest payments and principal.
• Amortization of Discounts and Premiums: Recorded as bond issuer makes interest payments.
• Bonds do not require amortization if issued at par.
• Amortization methods: effective-interest method preferred; straight-line method acceptable if not material.
• Maturity Date: The date when bond principal is repaid.
• Bond Interest Amortization Schedule: Helps track necessary entries for interest and discount/premium amortization.

Review Questions

Review #1

• The term used for bonds for which the principal is unsecured is (b) debenture bonds.

Review #2

• The face value of bonds is also called each of the following except (b) stated value.

Review #3

• Bond interest paid is equal to (c) face amount of the bonds * stated interest rate.