Principles of Financial Accounting: Long Term Liabilities - Bond Basics, Face Value Stated Rate Market Rate Secured vs. Unsecured Term vs. Serial Convertible Callable

What It Is

A bond is a type of long-term debt instrument issued by a company to raise capital from investors. It represents a promise to repay the face value (also known as the par value) of the bond, plus interest, at a specified maturity date. For example, if a company issues a $10,000 bond with a 5% annual interest rate, the investor will receive $10,000 at maturity and $500 in interest each year.

Key Concepts & Formulas

• Face Value: The amount borrowed by the company, also known as the par value. Example: A company issues a $10,000 bond with a 5% annual interest rate.
• Stated Rate: The interest rate stated on the bond, which may not be the actual market rate. Example: A bond has a stated rate of 5%, but the market rate is 6%.
• Market Rate: The current interest rate at which similar bonds are trading. Example: A bond has a market rate of 6%, which is higher than the stated rate of 5%.
• Secured vs Unsecured: A secured bond is backed by collateral, such as property or assets, while an unsecured bond is not. Example: A company issues a secured bond with a $10,000 face value and a 5% annual interest rate.
• Term vs Serial: A term bond has a single maturity date, while a serial bond has multiple maturity dates. Example: A company issues a term bond with a 5-year maturity date, while another company issues a serial bond with maturity dates every year for 5 years.
• Convertible: A convertible bond can be exchanged for a certain number of shares of the company's stock. Example: A company issues a convertible bond with a $10,000 face value and a 5% annual interest rate, which can be exchanged for 100 shares of the company's stock.
• Callable: A callable bond can be redeemed by the company before the maturity date. Example: A company issues a callable bond with a $10,000 face value and a 5% annual interest rate, which can be redeemed after 3 years.

Journal Entry Examples

1. Issuance of a Bond Dr. Cash $10,000 Cr. Bond Payable $10,000

Explanation: The company receives $10,000 in cash and records a liability for the bond payable.

1. Interest Expense Dr. Interest Expense $500 Cr. Bond Payable $500

Explanation: The company records interest expense for the year and reduces the bond payable liability.

1. Redemption of a Callable Bond Dr. Bond Payable $10,000 Cr. Cash $10,000

Explanation: The company redeems the callable bond and records a reduction in the bond payable liability and an increase in cash.

Common Mistakes

1. Mistake: Confusing debits and credits for bond payable accounts. Correction: Remember that bond payable is a liability account, which is debited when cash is received and credited when interest is recorded.
2. Mistake: Assuming that all bonds are secured. Correction: Not all bonds are secured, and some may be unsecured.
3. Mistake: Confusing term and serial bonds. Correction: A term bond has a single maturity date, while a serial bond has multiple maturity dates.

Exam Tips

1. Tip: Remember that bond payable is a liability account, which is debited when cash is received and credited when interest is recorded.
2. Tip: Be careful when dealing with callable bonds, as they can be redeemed before the maturity date.
3. Tip: Make sure to distinguish between term and serial bonds, as they have different maturity dates.

Quick Practice

1. Problem: A company issues a $10,000 bond with a 5% annual interest rate. What is the interest expense for the year? Answer: $500 Explanation: The company records interest expense for the year, which is 5% of the face value of the bond.

2. Problem: A company redeems a callable bond with a $10,000 face value and a 5% annual interest rate. What is the journal entry? Answer: Dr. Bond Payable $10,000, Cr. Cash $10,000 Explanation: The company redeems the callable bond and records a reduction in the bond payable liability and an increase in cash.

3. Problem: A company issues a convertible bond with a $10,000 face value and a 5% annual interest rate. What is the journal entry for the interest expense for the year? Answer: Dr. Interest Expense $500, Cr. Bond Payable $500 Explanation: The company records interest expense for the year and reduces the bond payable liability.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Face Value is the amount borrowed by the company.
3. Stated Rate is the interest rate stated on the bond.
4. Market Rate is the current interest rate at which similar bonds are trading.
5. Secured bonds are backed by collateral, while unsecured bonds are not.
6. Term bonds have a single maturity date, while serial bonds have multiple maturity dates.
7. Convertible bonds can be exchanged for a certain number of shares of the company's stock.
8. Callable bonds can be redeemed by the company before the maturity date.
9. Bond Payable is a liability account, which is debited when cash is received and credited when interest is recorded.
10. Interest Expense is recorded for the year, which is a percentage of the face value of the bond.