Principles of Financial Accounting

Chapter 9
Bond Accounting
(p. 390-404)

Introduction to Bonds
„ Bonds are formal certificates of debt that promise to pay:
9 A specified amount of interest in cash annually or semi-annually.
9 A specified principal at a specific maturity date. 3 “Convertible” bonds refer to
bonds that can be exchanged, at the
„ Vocabulary: holders’ option, for other securities.
Í Bonds are “issued” by companies (“issuers”) that wish to borrow
money from the general public.
Í Bonds are issued to multiple lenders / investors (“bondholders”).
Í The face value (also called par value or maturity value) is the
principal the company is required to pay at maturity.
Í The coupon rate (also called nominal interest rate, contractual rate,
stated rate) determines the amount of interest the company is required
to pay every year.
3 Bonds generally pay interest every 6 months (i.e. semi-annually).
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting 2

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 Valuing Bonds
„ Because bonds create cash flows in future periods, they are recorded
at the present value of those future payments, discounted at the
market interest rate in effect when the liability is created.

„ When valuing bonds, the present value tables are used to determine
the amount of proceeds that will be received (i.e. the “price” of the
bonds).
Í The present value of $1 table (Table 9A-2, p.422) is used to determine
the present value of the face amount (principal) of the bonds.
Í The present value of an annuity of $1 (Table 9A-3, p.423) is used to
determine the present value of the series of interest payments.
Í The amounts are added together to determine the amount of proceeds
and any resulting discount or premium.

Professor Lucile Faurel – Principles of Financial Accounting

Chapter 9 – Bond Accounting 3

Proceeds on Bond Issuance

Bond: Face Amount: $100,000
Term: 3 years
($100,000 * .07)/2
Coupon Rate: 7%
Interest Payments: $3,500 paid semi-annually

A. Market Interest Rate = 7% = Coupon Rate

9 Proceeds = $100,000.
9 Bond sold at par.
B. Market Interest Rate = 8% > Coupon Rate
9 Proceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377.
9 Bond sold at a discount.
4%, 6 periods, Table 9A-3
4%, 6 periods, Table 9A-2
C. Market Interest Rate = 6% < Coupon Rate
9 Proceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710.
9 Bond sold at a premium.
3%, 6 periods, Table 9A-2 3%, 6 periods, Table 9A-3

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Chapter 9 – Bond Accounting 4

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 Par, Discount & Premium
9 If the market rate is EQUAL to the coupon rate,
the bond will sell at PAR.

9 If the market rate is ABOVE the coupon rate,

the bond will sell at a DISCOUNT.

9 If the market rate is BELOW the coupon rate,

the bond will sell at a PREMIUM.

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Chapter 9 – Bond Accounting 5

Coupon Rate vs. Market Rate

„ The coupon (interest) rate is:
Í The rate of interest stated on the bond.
Í The interest to be paid in cash every year by the issuing company.
q Used to calculate the amount of interest payments (paid in cash).

„ The market (interest) rate (or effective interest rate, yield to maturity) is:
Í The rate available on investments in similar bonds at a moment in time.
q Used in the present value calculations when determining the
proceeds on issuance.
q Used to calculate the amount of interest expense to recognize.
3Changes in the market rate after the bonds are issued do NOT affect the interest
expense recognized.
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 Effective Interest Amortization
„ How do we decrease the bond discount or bond premium?
Í Straight-line amortization (not GAAP)
9 The discount or premium is amortized in equal amounts each period.
Í Effective interest amortization
9 The discount or premium is amortized over the life of the debt.
9 The interest expense is equal to the market interest rate
(at the time of issuance) multiplied by the amount of debt
outstanding at the beginning of the given period.
9 The difference between the interest expense and the cash
paid (for interest payments) represents the amortization of
the discount or premium.

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Chapter 9 – Bond Accounting 7

Discount Amortization
Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).
Period Bonds Interest Cash Amortization of Bonds
Payable, Expense Payment Discount Payable,
Beg. (4%) End
(a) (b=a*4%) (c) (d=b-c) (e=a+d)
1 97,377 3,895 3,500 395 97,772
2 97,772 3,911 3,500 411 98,183
3 98,183 3,927 3,500 427 98,610
4 98,610 3,944 3,500 444 99,055
5 99,055 3,962 3,500 462 99,517
6 99,517 3,983 3,500 483 100,000
Í Journal entry upon bond issuance:
Dr. Cash 97,377
Cr. Bonds Payable 97,377
Í Journal entry for interest expense, end of Period 1 (6 months after issuance):
Dr. Interest Expense 3,895
Cr. Cash (or Interest Payable) 3,500
Cr. Bonds Payable 395
Í Journal entry at maturity (end of Period 6):
Dr. Bonds Payable 100,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting
Cr. Cash 100,000 8

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 Premium Amortization
Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).
Period Bonds Interest Cash Amortization of Bonds
Payable, Expense Payment Premium Payable,
Beg. (3%) End
(a) (b=a*3%) (c) (d=b-c) (e=a+d)
1 102,710 3,081 3,500 -419 102,291
2 102,291 3,069 3,500 -431 101,860
3 101,860 3,056 3,500 -444 101,416
4 101,416 3,042 3,500 -458 100,958
5 100,958 3,029 3,500 -471 100,487
6 100,487 3,013 3,500 -487 100,000
Í Journal entry upon bond issuance:
Dr. Cash 102,710
Cr. Bonds Payable 102,710
Í Journal entry for interest expense, end of Period 4 (2 years after issuance):
Dr. Interest Expense 3,042
Dr. Bonds Payable 458
Cr. Cash (or Interest Payable) 3,500
Í Journal entry at maturity (end of Period 6):
Dr. Bonds Payable 100,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting
Cr. Cash 100,000 9

Bond Issued at Par

Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).
Period Bonds Interest Cash Amortization of Bonds
Payable, Expense Payment Discount / Payable,
Beg. (3.5%) Premium End
(a) (b=a*3.5%) (c) (d=b-c) (e=a+d)
1 100,000 3,500 3,500 - 100,000
2 100,000 3,500 3,500 - 100,000
3 100,000 3,500 3,500 - 100,000
4 100,000 3,500 3,500 - 100,000
5 100,000 3,500 3,500 - 100,000
6 100,000 3,500 3,500 - 100,000
Í Journal entry upon bond issuance:
Dr. Cash 100,000
Cr. Bonds Payable 100,000
Í Journal entry for interest expense at the end of each period:
Dr. Interest Expense 3,500
Cr. Cash (or Interest Payable) 3,500
Í Journal entry at maturity (end of Period 6):
Dr. Bonds Payable 100,000
Cr. Cash 100,000
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 Practice Problem A
„ A company issues a 2-year bond with a face value of $20,000 and a
coupon rate of 10%.
Í Interest is paid and compounded semi-annually on June 30 and
December 31 of each year.
Í At the time of issuance, the market rate is 12%.
1. What is the amount of the proceeds from the issuance of this bond?
9 Proceeds = $20,000 * 0.7921 + $1,000 * 3.4651 = $19,307.
9 Bond sold at a discount.
6%, 4 periods, Table 9A-3
6%, 4 periods, Table 9A-2

Interest payment =
($20,000 * 10%)/2 =
$20,000 * 5% = $1,000

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Chapter 9 – Bond Accounting 11

Practice Problem A
„ A company issues a 2-year bond with a face value of $20,000 and a
coupon rate of 10%. At the time of issuance, the market rate was 12%.
2. Write out ALL journal entries related to this bond (i.e. from issuance
until maturity).
Issuance, beg of period 1: End of period 3:
Dr. Cash 19,307 Dr. Interest Expense (19,633*.06) 1,178
Cr. Bonds Payable 19,307 Cr. Cash 1,000
Cr. Bonds Payable 178
End of period 1:
Dr. Interest Expense (19,307*.06) 1,158 End of period 4:
Cr. Cash 1,000 Dr. Interest Expense (19,811*.06) 1,189
Cr. Bonds Payable 158 Cr. Cash 1,000
Cr. Bonds Payable 189
End of period 2: 19,307+158
Dr. Interest Expense (19,465*.06) 1,168 Maturity, end of period 4:
Cr. Cash 1,000 Dr. Bonds Payable 20,000
Cr. Bonds Payable 168 Cr. Cash 20,000
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 Practice Problem B
„ A company issues a 2-year bond with a face value of $20,000 and a
coupon rate of 10%.
Í Interest is paid and compounded semi-annually on June 30 and
December 31 of each year.
Í At the time of issuance, the market rate is 8%.
1. What is the amount of the proceeds from the issuance of this bond?
9 Proceeds = $20,000 * 0.8548 + $1,000 * 3.6299 = $20,726.
9 Bond sold at a premium.
4%, 4 periods, Table 9A-3
4%, 4 periods, Table 9A-2

Interest payment =
($20,000 * 10%)/2 =
$20,000 * 5% = $1,000

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Chapter 9 – Bond Accounting 13

Practice Problem B
„ A company issues a 2-year bond with a face value of $20,000 and a
coupon rate of 10%. At the time of issuance, the market rate was 8%.
2. Write out ALL journal entries related to this bond (i.e. from issuance
until maturity).
Issuance, beg of period 1: End of period 3:
Dr. Cash 20,726 Dr. Interest Expense (20,377*.04) 815
Cr. Bonds Payable 20,726 Dr. Bonds Payable 185
Cr. Cash 1,000
End of period 1:
Dr. Interest Expense (20,726*.04) 829 End of period 4:
Dr. Bonds Payable 171 Dr. Interest Expense (20,192*.04) 808
Cr. Cash 1,000 Dr. Bonds Payable 192
Cr. Cash 1,000
End of period 2: 20,726-171
Dr. Interest Expense (20,555*.04) 822 Maturity, end of period 4:
Dr. Bonds Payable 178 Dr. Bonds Payable 20,000
Cr. Cash 1,000 Cr. Cash 20,000
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 Early Extinguishment of Bonds
„ Firms that issue bonds do not always hold the bonds to maturity.
9 They can repurchase bonds on the open market, or
9 They can call back bonds at a pre-specified price (if the bonds are issued
with a “call” provision).

„ Early extinguishments of debt usually result in a gain or loss.

Í Gain (loss) on early extinguishment = Book value of debt – price
paid for debt (i.e. market value).
9 Book value of bond = face value – unamortized discount or premium
= balance of Bonds Payable account at the time of the early extinguishment.

Í Since 2002, gains and losses from early extinguishment of debt are
usually classified as “other income” on the income statement.
9 Special item “above the line,” i.e. not included in operating income.

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Chapter 9 – Bond Accounting 15

CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
Fiscal Year Ended April 30,
(in thousands) 2002 2003 2004

Revenues $ 421,235 $ 420,863 $ 439,686

Operating expenses:
Cost of operations 276,693 278,347 287,309
General and administration 54,456 55,772 58,198
Depreciation and amortization 50,712 47,930 59,673
Impairment charge — 4,864 1,663
Restructuring charge (438) — —
381,423 386,913 406,843
Operating income 39,812 33,950 32,843
Other expense/(income), net:
Interest income (904) (318) (251)
Interest expense 31,451 26,572 25,648
Income from equity method investments (1,899) (2,073) (2,261)
Loss on debt extinguishment — 3,649 —
Minority interest (154) (152) —
Other expense/(income) (4,480) (1,599) 5,948
Other expense, net 24,014 26,079 29,084
Income from continuing operations 15,798 7,871 3,759
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 Early Extinguishment of Bonds
Journal Entry
„ Consider the discount bond examined in slide 8. The company decides
to repurchase this bond on the first day of Year 3.
Í At the end of Year 2 (i.e. Period 4), the book value is $99,055.
Í Assume the company repurchases the bond for $90,000:
9 Gain (Loss) = $99,055 – $90,000 = $9,055 of GAIN.
Dr. Bonds Payable 99,055
Cr. Cash 90,000
Cr. Gain on Early Extinguishment 9,055
Í Now, assume the company repurchases the bond for $110,000:
9 Gain (Loss) = $99,055 – $110,000 = $(10,945) of LOSS.
Dr. Bonds Payable 99,055
Dr. Loss on Early Extinguishment 10,945
Cr. Cash 110,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting 17

Noninterest-Bearing Bonds
„ Noninterest-bearing bonds (also called zero coupon bonds):
Í Pay no interest (i.e. the coupon rate is 0%) during their life and thus
are issued at very deep discounts.

„ Example:
Í Consider a 4-year zero coupon bond with a face value of $1,000.
The market rate at the time of issue is 10% (compounded semi-annually).
Í Journal entry to record the issuance:
9 Proceeds = 1,000 * 0.6768 = $677. 5%, 8 periods, Table 9A-2

9 Journal entry:
Dr. Cash 677
Cr. Bonds Payable 677

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 Noninterest-Bearing Bonds
„ Example (cont’d):
Í Amortization schedule:
Period Bonds Interest Cash Amortization of Bonds
Payable, Expense Payment Discount Payable,
Beg. (5%) End
(a) (b=a*4%) (c) (d=b-c) (e=a+d)
1 677 34 – 34 711
2 711 36 – 36 747
3 747 37 – 37 784
4 784 39 – 39 823
5 823 41 – 41 864
6 864 43 – 43 907
7 907 45 – 45 952
8 952 48 – 48 1,000

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Chapter 9 – Bond Accounting 19

Noninterest-Bearing Bonds
„ Example (cont’d):
Í Journal entries to record accrued interest:
677 * .05
At end of period 1: At end of period 5:
Dr. Interest Expense 34 Dr. Interest Expense 41
Cr. Bonds Payable 34 Cr. Bonds Payable 41
(677+34) * .05
At end of period 2: At end of period 6:
Dr. Interest Expense 36 Dr. Interest Expense 43
Cr. Bonds Payable 36 Cr. Bonds Payable 43

At end of period 3: At end of period 7:

Dr. Interest Expense 37 Dr. Interest Expense 45
Cr. Bonds Payable 37 Cr. Bonds Payable 45

At end of period 4: At end of period 8:

Dr. Interest Expense 39 Dr. Interest Expense 48
Cr. Bonds Payable 39 Cr. Bonds Payable 48

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