LONG-TERM LIABILITIES: BONDS AND NOTES

Financing Corporations
A bond is an interest-bearing note that requires periodic interest payments, with the face amount to be
repaid at the maturity date.
One of the main factors that influences the decision to issue debt or equity is the effect that various
financing alternatives will have on earnings per share. Earnings per share (EPS) measures the income
earned by each share of common stock.

Bond Characteristics and Terminology

The face amount of each bond is called the principal. The underlying contract between the company
issuing bonds and the bondholders is called a bond indenture. The two most common types of bonds
are term bonds and serial bonds. When all bonds of an issue mature at the same time, they are called
term bonds. If the bonds mature over several dates, they are called serial bonds.

Proceeds from Issuing Bonds

When a corporation issues bonds, the proceeds received for the bonds depend on the following:
• The face amount of the bonds, which is the amount due at the maturity date
• The interest rate on the bonds
• The market rate of interest for similar bonds
The face amount and the interest rate on the bonds are identified in the bond indenture. The interest
rate to be paid on the face amount of the bond is called the contract rate or coupon rate. The market
rate of interest, sometimes called the effective rate of interest, is the rate determined from sales and
purchases of similar bonds.
Issuing Bonds at a Discount, at Face Amount, and at a Premium

A bond sells at a discount because buyers are not willing to pay the full face amount for bonds with a
contract rate that is lower than the market rate. A bond sells at a premium because buyers are willing to
pay more than the face amount for bonds with a contract rate that is higher than the market rate.

Accounting for Bonds Payable

When bonds are issued at less or more than their face amount, the discount or premium must be
amortized over the life of the bonds. At the maturity date, the face amount must be repaid.
• Bonds Issued at Face Amount
To illustrate, assume that on January 1, 20Y5, Eastern Montana Communications Inc. issued the
following bonds:
 Since the contract rate of interest and the market rate of interest are the same, the bonds will
sell at their face amount. The entry to record the issuance of the bonds is as follows:

Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000
($100,000 * 12% * ½ year) is paid. The first interest payment on June 30, 20Y5, is recorded as
follows:

At the maturity date, the payment of the principal of $100,000 is recorded as follows:

• Bonds Issued at a Discount

Assuming that the bonds sell for $96,406, the entry to record the issuance of the bonds is as
follows:

The carrying amount of bonds payable is the face amount of the bonds less any unamortized
discount or plus any unamortized premium. Thus, after the preceding entry, the carrying
amount of the bonds payable is $96,406 ($100,000 2 $3,594).
• Amortizing a Bond Discount
The entry to amortize a bond discount is as follows:

The preceding entry may be made annually as an adjusting entry, or it may be combined with
the semiannual interest payment. In the latter case, the entry would be as follows:
 The straight-line method is used to compute the amortization of a bond discount.

The combined entry to record the first interest payment and the amortization of the discount is
as follows:

• Bonds Issued at a Premium

To illustrate, assume that on January 1, 20Y5, Northern Idaho Transportation Inc. issued the
following bonds:

Assuming that the bonds sell for $103,769, the entry to record the issuance of the bonds is as
follows:

• Amortizing a Bond Premium

The entry to amortize a bond premium is as follows:

The preceding entry may be made annually as an adjusting entry, or it may be combined with
the semiannual interest payment. In the latter case, it would be:

The combined entry to record the first interest payment and the amortization of the premium is
as follows:
Bond Redemption
o Callable bonds can be redeemed by the issuing corporation within the period of time and at the
price stated in the bond indenture. Normally, the call price is above the face value.
o A gain or loss may be realized on a bond redemption as follows:
• A gain is recorded if the price paid for redemption is below the bond carrying amount.
• A loss is recorded if the price paid for the redemption is above the carrying amount.
To illustrate, assume that on June 30, 20Y5, a corporation has the following bond issue:

On June 30, 20Y5, the corporation redeemed one-fourth ($25,000) of these bonds in the market for
$24,000. The entry to record the redemption is as follows:

In the preceding entry, only the portion of the premium related to the redeemed bonds ($4,000 × 25% =
$1,000) is removed. The difference between the carrying amount of the bonds redeemed, $26,000
($25,000 + $1,000), and the redemption price, $24,000, is recorded as a gain.
Assume that the corporation calls the remaining $75,000 of outstanding bonds, which are held by a
private investor, for $79,500 on July 1, 20Y5. The entry to record the redemption is as follows:

Installment Notes
Unlike bonds, each note payment includes the following:
• Payment of a portion of the amount initially borrowed, called the principal
• Payment of interest on the outstanding balance
When a note is secured by an asset, it is called a mortgage note.
Issuing an Installment Note
To illustrate, assume that Lewis Company issues the following installment note to City National Bank on
January 1, 20Y4:
Annual Payments

The entry to record the first payment on December 31, 20Y4, is as follows:

The entry to record the second payment on December 31, 20Y5, is as follows:

As the prior entries show, the cash payment is the same in each year.

Reporting Long-Term Liabilities

Bonds payable and notes payable are reported as liabilities on the balance sheet. Any portion of the
bonds or notes that is due within one year is reported as a current liability. Any remaining bonds or
notes are reported as a long-term liability.
Any unamortized premium is reported as an addition to the face amount of the bonds. Any unamortized
discount is reported as a deduction from the face amount of the bonds.

Present Value Concepts and Pricing Bonds Payable

Pricing Bonds
The market rate of interest is used to compute the present value of both the face amount and the
periodic interest.
Assuming a market rate of interest of 12%, the bonds would sell for their face amount. As shown by the
following present value computations, the bonds would sell for $100,000:

Amortization of Discount by the Interest Method

The interest rate used in the effective interest rate method of amortization, sometimes called the
interest method, is the market rate on the date the bonds are issued.
To illustrate, the following data taken from the chapter illustration of issuing bonds at a discount are
used:

The entry to record the first interest payment on June 30, 20Y5, and the related discount amortization is
as follows:

Amortization of Premium by the Interest Method

To illustrate, the following data taken from the chapter illustration of issuing bonds at a premium are
used:
The entry to record the first interest payment on June 30, 20Y5, and the related premium amortization
is as follows: