Intermediate Accounting 2

5
“BONDS PAYABLE”

MS. MARY JOY F. LABAJO

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Intermediate Accounting 2

“BONDS PAYABLE”

• To understand the nature and purpose of a bond.

• To identify the types of bond.
• To know the measurement of bonds payable.
• To understand the concept of bond premium bond discount.
• To describe the methods of amortizing bond premium and
bond discount.
• To apply the fair value option of measuring bonds payable.
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DEFINITION OF BOND
Whenever funds being borrowed can be obtained from a
small number of sources, mortgages or notes are usually used.

However, when large amounts are needed, an entity may have

to borrow from the general investing public through the use
of a bond issue.

Bonds are used primarily by corporations and government

units.
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“Thankfulness is an attitude of possibilities,

not an attitude of liabilities.”
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A bond is a formal unconditional promise, made under seal, to pay

a specified sum of money at a determinable future date, and to
make periodic interest payment at a stated rate until the principal
sum is paid.

In simple language, a bond is a contract of debt whereby one

party called the issuer borrows funds from another party called
the investor.

A bond is evidenced by a certificate and the contractual agreement

between the issuer and investor is contained in a document known
as "bond indenture".
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Term and serial bonds

Term bonds are bonds with a single date of maturity.

Term bonds may require the issuing entity to establish a sinking

fund to provide adequate money to retire the bond issue at one
time.

Serial bonds are bonds with a series of maturity dates instead of

a single one.

In other words, serial bonds allow the issuing entity to retire the
bonds by installments.
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Secured and unsecured bonds

Mortgage bonds are bonds secured by a mortgage on real

properties.

Collateral trust bonds are bonds secured by shares and bonds of

other corporation.

Debenture bonds are unsecured or bonds without collateral

security.
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Registered and bearer bonds

Registered bonds require the registration of the name of the

bondholders on the books of the corporation.

If the bondholder sells a bond, the old bond certificate is

surrendered to the entity and a new bond certificate is-issued to
the buyer. Interest is periodically paid by the issuing entity to
bondholders of record.
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Coupon or bearer bonds are unregistered bonds in the sense that

the name of the bondholder is not recorded on the entity books.

The issuing entity does not maintain a record of who owns the
bonds at any point in time.

Thus, interest on coupon bonds is paid to the person submitting

a detachable interest coupon.
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Other types of bonds

Convertible bonds are bonds that can be exchanged for shares of

the issuing entity.

Callable bonds are bonds which may be called in for redemption

prior to the maturity date.

Guaranteed bonds are bonds issued whereby another party

promises to make payment if the borrower fails to do
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Junk bonds are high-risk, high-yield bonds issued by entities that

are heavily indebted or otherwise in weak financial condition.

Zero-coupon bonds are bonds that pay no interest, but the bonds
offer a return in the form of a "deep discount” or huge discount
from the face amount.
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Features of bond issue

a. A bond indenture or deed of trust is the document which

shows in detail the terms of the loan and the rights and
duties of the borrower and other parties to the contract.

b. Bond certificates are used. Each bond certificate represents a

portion of the total loan. The usual minimum denomination
in business practice is P 1,000, although smaller
denominations may be issued occasionally.
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c. If property is pledged as security for the loan, a trustee is

named to hold title to the property serving as security. The
trustee acts as the representative of the bondholders and is
usually a bank or trust entity.
d. A bank or trust entity is usually appointed as registrar or
disbursing agent. The borrower deposits interest and principal
payments with the disbursing agent, who then distributes the
funds to the bondholders.
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Contents of bond indenture

The bond indenture is the contract between the bondholders
and the borrower or issuing entity- Normally, the bond
indenture contains the following items:

a. Characteristics of the bonds

b. Maturity date and provision for repayment
c. Period of grace allowed to issuing entity
d. Establishment of a sinking fund and the periodic deposit
therein.
e. Deposit to cover interest payments
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f. Provisions affecting mortgaged property, such as taxes,

insurance coverage, collection of interest or dividends on
collaterals
g. Access to corporate books and records of trustee
h. Certification of bonds by trustee
i. Required debt to equity ratio
j. Minimum working capital to be maintained, if any.
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Sale of bonds

The bonds needed for the issuance of bonds are usually too large
for one buyer to pay. Thus, very often, the bonds are divided into
various denominations of say P 100, P1,000, P 10,000, thus
enabling more than one buyer or investor to purchase the bonds.

Quite often, however, instead of selling bonds of various

denominations, the bonds are sold in equal denominations of say
P 1,000 only. The P 1,000 denomination is called the face amount
of the bonds. Each bond is evidenced by a certificate called a
bond certificate.
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Thus, if bonds with face amount of P50,000,000 are sold, divided

into P1,000 denomination, there shall be 50,000 bond certificates
containing a face amount of P 1,000.

When an entity sells a bond issue, it undertakes to pay the face

amount of the bond issue on maturity date and the periodic
interest.
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Interest is usually payable semiannually or every six months as

follows:
a. January 1 and July 1
b. February 1 and August 1
c. March 1 and September 1
d. April 1 and October 1
e. May 1 and November 1
f. June 1 and December 1

Of course, there are certain bonds that pay interest annually or

at the end of every bond year.
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Initial measurement of bonds payable

PFRS 9, paragraph 5.1.1, provides that bonds payable not

designated at fair value through profit or loss shall be measured
initially at fair value minus transaction costs that are directly
attributable to the issue of the bonds payable.

The fair value of the bond's payable is equal to the present

value of the future cash payments to settle the bond liability.
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Bond issue costs shall be deducted from the fair value or issue
price of the bonds payable in measuring initially the bonds
payable.

However, if the bonds are designated and accounted for "at fair
value through profit or loss", the bond issue costs are treated as
expense immediately.

Actually, the fair value of the bond's payable is the same as the
issue price or net proceeds from the issue of the bonds,
excluding accrued interest.
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Subsequent measurement of bonds payable

PFRS 9, paragraph 5.3.1, provides that after initial recognition,

bonds payable shall be measured either:

a. At amortized cost, using the effective interest method

b. At fair value through profit or loss
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Amortized cost of bonds payable

The amortized cost of bonds payable is the amount at which the

bond liability is measured initially minus principal repayment,
plus or minus the cumulative amortization using the effective
interest method of any difference between the face amount and
present value of the bonds payable.

Actually, the difference between the face amount and present

value is either discount or premium on the issue of the bonds
payable.
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Accounting for issuance of bonds

There are two approaches in accounting for the authorization and

issuance of bonds, namely:

a. Memorandum approach
b. Journal entry approach
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Illustration
On January 1, 2020, an entity is authorized to issue 10-year: 12%
bonds with face amount of P5,000,000, interest payable January 1
and July 1, consisting of 5,000 units of P1,000 face amount. The
bonds are sold at face amount to an underwriter.

Memorandum approach
The following memorandum entry is made in the general journal
and a notation of the amount authorized:

On January 1, 2020, the entity is authorized to issue P5,000,000 face

amount, 10-year 12% bonds, interest payable January 1 and July 1,
consisting of 5,000 units of P 1,000 face amount.
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To record the sale of the bonds at face amount:

Cash 5,000,000
Bonds payable 5,000,000

In the succeeding discussions, the memorandum approach of

accounting for bonds will be employed, as this is the one
generally followed.
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Journal entry approach

To record the authorization of the bonds:

Unissued bonds payable 5,000,000

Authorized bonds payable 5,000,000

To record the sale of the bonds at face amount:

Cash 5,000,000
Unissued bonds payable 5,000,000
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Issuance of bonds at a premium

If the sales price is more than the face amount of the bonds, the
bonds are said to be sold at a premium.

For example, an entity issued bonds with face amount of

P5,000,000 at 105. The quoted price of 105 means "105% of the
face amount of the bonds." Thus, the sales price is P5,250,000,
computed by multiplying 105% by P5,000,000.
Journal entry
Cash 5,250,000
Bonds payable 5,000,000
Premium on bonds payable 250,000
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Intermediate Accounting 2

The bond premium is in effect a gain on the part of the issuing

entity because it receives more than what it is obligated to pay
under the terms of the bond issue. The obligation of the issuing
entity is limited only to the face amount of the bonds.

The bond premium however is not reported as an outright gain.

When the bonds are sold at a premium, it means that the
investor or the buyer is amenable to receive interest that is
somewhat less than the nominal or stated rate of interest.

Thus, in such a case, the effective rate is less than the nominal
rate of interest.
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Intermediate Accounting 2

The nominal rate of interest is the rate appearing on the face of

the bond certificate. It is that interest which the issuing entity
periodically pays to the buyer or bondholder.

Because of the relationship of the premium to the interest, the

bond premium is amortized over the life of the bonds and
credited to interest expense.
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Intermediate Accounting 2

Accordingly, if the bonds have a 10-year life and the straight-line

method is used for simplicity, the entry to record the amortization
of the bond premium is:

Premium on bonds payable 25,000

Interest expense (250,000 / 10 years) 25,000
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Issuance of bonds at a discount

If the sales price of the bonds is less than the face amount, the
bonds are said to be sold at a discount.

For example, an entity issued bonds with face amount of

P5,000,000 at 95.

Journal entry

Cash (5,000,000 x 95%) 4,750,000

Discount on bonds payable 250,000
Bonds payable 5,000,000
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Intermediate Accounting 2

The bond discount is in effect a loss to the issuing entity; However,

it is not treated as an outright loss.

When bonds are sold at a discount, it means that the buyer or

investor is not willing to accept simply the nominal rate of interest.

The buyer wants to accept a rate of interest that is somewhat

higher than the nominal rate.

Thus, when bonds are issued at a discount, the effective rate is

higher than the nominal rate.
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Intermediate Accounting 2

Accounting wise, the bond discount is amortized as loss over the

life of the bonds and charged to interest expense.

Thus, if the bonds have a life of 10 years and the straight-line

method is used, the journal entry to record the amortization of the
bond discount is:

Interest expense (250,000/10 years) 25,000

Discount on bonds payable 25,000
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Intermediate Accounting 2

Presentation of discount and premium

Discount on bond payable and premium on bond payable are

reported as adjustments to the bond liability account.

The discount on bond payable is a deduction from the bond

payable and the premium on bond payable is an addition to
the bond payable.

This treatment is on the theory that the discount represents an

amount that the issuer cannot borrow because of interest
differences, and the premium represents an amount in excess
of face amount that the issuer is able to borrow.
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Intermediate Accounting 2

The discount on bonds payable and the premium on bonds

payable shall not be considered separate from the bonds payable
account. Both accounts shall be treated consistently as valuation
accounts of the bond liability.
Observe the following presentation in the statement of financial
position.
Noncurrent liabilities:
Bonds payable 5,000,000
Discount on bonds payable (250,000) 4,750,000
and
Noncurrent liabilities:
Bonds payable 5,000,000
Premium on bonds payable 250,000 5,250,000
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Intermediate Accounting 2

Bond issue costs

Bond issue costs are transaction costs directly attributable to the

issue of bonds payable.

Such costs include printing and engraving cost, legal and

accounting fee, registration fee with regulatory authorities,
commission paid to agents and underwriters and other similar
charges.
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Intermediate Accounting 2

Under PFRS 9, bond issue costs shall be deducted from the fair
value or issue price of bonds payable in measuring initially the
bonds payable.

Under the effective interest method of amortization, the bond

issue cost must be "lumped" with the discount on bonds payable
and "netted" against the premium on bonds payable.

However, if the bonds are measured at fair value through profit

or loss, the bond issue costs are expensed immediately.
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Intermediate Accounting 2

Recording interest on bonds

Accounting for interest expense on bonds requires recognition of

two items, namely:

a. Payment of interest during the year

b. Accrual of interest at the end of the year
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Intermediate Accounting 2

Illustration

On March 1, 2020, an entity sold bonds with face amount of

P5,000,000 and 12% interest payable semiannually on March 1
and September 1.

In as much as the bonds are sold on March 1, 2020, the first

payment of interest will be on September 1, 2020.
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Issuance of bonds on interest date

On June 1, 2020, an entity issued bonds with face amount of

P5,000,000 at 97.

The bonds mature in 5 years and pay 12% interest semiannually

on June 1 and December 1.

The straight-line method is used for simplicity in amortizing

discount on bonds payable.
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The amortization of the bond discount or premium may be on

every interest date or at the end of every year.

In the given example, the amortization is made at the end of the

year.
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If a statement of financial position is prepared on December 31,

2021, the accrued interest payable of P50,000 is classified as
current liability.

The bonds payable should be classified as noncurrent liability:

Bonds payable 5,000,000

Discount on bonds payable ( 102,500)
Carrying amount 4,897,500
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Note that if the bonds are issued between interest dates, an

accrued interest is involved.

Normally, when bonds are issued between interest dates, the

accrued interest is paid by the buyer or investor.

The accrued interest on the date of sale for 3 months from

January 1 to April 1, 2020, is paid by the investor because on July
1, 2020, three months after the sale, the investor is going to
receive interest for 6 months from January 1 to July 1, 2020.

The accrued interest "sold" is credited to interest expense.

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Intermediate Accounting 2

On July 1, 2020, the journal entry to record the payment of

semiannual interest is:

Interest expense (5,000,000 x 12% x 1/ 2) 300,000

Cash 300,000

Note that if at this point the interest expense account is posted, it

has a debit balance of P150,000 which represents the correct
amount of interest expense from April 1 to July 1, 2020.
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Intermediate Accounting 2

Another approach for the interest accrued

Another approach is to credit the accrued interest on the date of
sale to accrued interest payable account.
Cash 5,378,000
Bonds payable 5,000 000
Premium on bonds payable 228,000
Accrued Interest payable 150,000
The payment of first semiannual interest is recorded as:
Accrued interest payable 150,000
Interest expense 150,000
Cash 300,000
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Intermediate Accounting 2

In either approach, the debit balance of the interest expense

account must be P 150,000, the correct interest expense.

The approach of crediting interest expense instead of accrued

interest payable is preferable.

Continuing the illustration, on December 31, 2020, the adjusting

entries are:
a. Interest expense 300,000
Accrued interest payable 300,000
Interest accrued for 6 months from
July 1 to December 31, 2020
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Intermediate Accounting 2

b. Premium on bonds payable 36,000

Interest expense 36,000
Original life of bonds (5 years x 12) 60 months
Less: Expired life on the date of sale
(January 1 to April 1) 3 months
Remaining life of bonds 57 months
Monthly amortization (228,000/57 months) 4,000
Amortization for 9 months from
April 1 to December 31, 2020 (4,000 x 9) 36,000

The straight-line method is used in amortizing the premium on

bonds payable for simplicity.
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Bond retirement on maturity date

To make a bond issue more attractive, an entity may agree in the
bond indenture to establish a sinking fund exclusively for use in
retiring the bonds at maturity.

The periodic cash deposits plus the interest earned on sinking fund
securities should cause the fund to approximately equal the
amount of bond issue on maturity date.

When the bonds approach maturity date, the trustee sells the
securities and uses the sinking fund cash to pay the bondholders.
Any excess cash is returned to the issuing entity.
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“Laziness requires no effort, whereas work

requires dedication and perseverance.”

-Catherine Pulsifer