Principles of Financial Accounting: Long Term Liabilities - Issuing Bonds Par Discount Premium, Journal Entries

What It Is

Issuing bonds is a common method for companies to raise capital by selling debt securities to investors. When a company issues bonds, it promises to repay the face value (also known as the par value) of the bond plus interest over a specified period. The bond's face value is the amount the company receives from selling the bond, while the interest is the periodic payment made to the bondholder. For example, if a company issues a $100,000 bond with a 5% annual interest rate, it will pay $5,000 in interest each year.

Key Concepts & Formulas

• Face Value: The amount the company receives from selling the bond.
  • Example: A company issues a $100,000 bond with a 5% annual interest rate.
• Par Value: The face value of the bond, which is the amount the company promises to repay.
  • Example: The par value of the $100,000 bond is $100,000.
• Discount: The difference between the face value and the amount the company receives from selling the bond.
  • Example: If the company sells the bond for $95,000, the discount is $5,000 ($100,000 - $95,000).
• Premium: The difference between the face value and the amount the company receives from selling the bond when the bond is sold at a price higher than the face value.
  • Example: If the company sells the bond for $105,000, the premium is $5,000 ($105,000 - $100,000).
• Interest Rate: The periodic payment made to the bondholder, expressed as a percentage of the face value.
  • Example: The 5% annual interest rate on the $100,000 bond is $5,000.
• Amortization: The process of gradually reducing the discount or premium over the life of the bond.
  • Example: If the discount is $5,000, the company will amortize it over the life of the bond, reducing the discount by $1,250 each year ($5,000 / 4 years).
• Bond Issue Costs: The expenses incurred by the company when issuing the bond, such as underwriting fees and legal fees.
  • Example: The company incurs $10,000 in bond issue costs.

Journal Entry Examples

Example 1: Issuing a Bond at Face Value

Dr. Cash $100,000 Cr. Bond Payable $100,000

Explanation: The company receives $100,000 from selling the bond and records it as cash. The bond payable account is credited to reflect the company's obligation to repay the face value of the bond.

Example 2: Issuing a Bond at a Discount

Dr. Cash $95,000 Cr. Bond Payable $95,000 Cr. Discount on Bond Payable $5,000

Explanation: The company receives $95,000 from selling the bond and records it as cash. The bond payable account is credited to reflect the company's obligation to repay the face value of the bond. The discount on bond payable account is credited to reflect the discount on the bond.

Example 3: Amortizing a Discount

Dr. Discount on Bond Payable $1,250 Cr. Interest Expense $1,250

Explanation: The company amortizes the discount on the bond payable by debiting the discount account and crediting interest expense. This reduces the discount and recognizes the interest expense.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

• Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity. For example, if a company incurs $10,000 in bond issue costs, it will debit the expense account and credit the cash account.

Mistake 2: Failing to Amortize Discounts and Premiums

• Correction: Discounts and premiums must be amortized over the life of the bond. For example, if a company issues a bond at a discount, it will amortize the discount by debiting the discount account and crediting interest expense each year.

Mistake 3: Ignoring Bond Issue Costs

• Correction: Bond issue costs must be recorded as an expense. For example, if a company incurs $10,000 in bond issue costs, it will debit the expense account and credit the cash account.

Exam Tips

Tip 1: Remember that Debits Increase Assets and Expenses

• Example: If a company incurs $10,000 in bond issue costs, it will debit the expense account and credit the cash account.

Tip 2: Amortize Discounts and Premiums

• Example: If a company issues a bond at a discount, it will amortize the discount by debiting the discount account and crediting interest expense each year.

Tip 3: Record Bond Issue Costs as an Expense

• Example: If a company incurs $10,000 in bond issue costs, it will debit the expense account and credit the cash account.

Quick Practice

Problem 1: Issuing a Bond at Face Value

A company issues a $100,000 bond at face value. What is the journal entry to record the issuance of the bond?

Answer: Dr. Cash $100,000 Cr. Bond Payable $100,000

Explanation: The company receives $100,000 from selling the bond and records it as cash. The bond payable account is credited to reflect the company's obligation to repay the face value of the bond.

Problem 2: Issuing a Bond at a Discount

A company issues a $100,000 bond at a discount of $5,000. What is the journal entry to record the issuance of the bond?

Answer: Dr. Cash $95,000 Cr. Bond Payable $95,000 Cr. Discount on Bond Payable $5,000

Explanation: The company receives $95,000 from selling the bond and records it as cash. The bond payable account is credited to reflect the company's obligation to repay the face value of the bond. The discount on bond payable account is credited to reflect the discount on the bond.

Problem 3: Amortizing a Discount

A company issues a bond at a discount of $5,000. What is the journal entry to amortize the discount over the life of the bond?

Answer: Dr. Discount on Bond Payable $1,250 Cr. Interest Expense $1,250

Explanation: The company amortizes the discount on the bond payable by debiting the discount account and crediting interest expense. This reduces the discount and recognizes the interest expense.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Face Value: The amount the company receives from selling the bond.
3. Par Value: The face value of the bond, which is the amount the company promises to repay.
4. Discount: The difference between the face value and the amount the company receives from selling the bond.
5. Premium: The difference between the face value and the amount the company receives from selling the bond when the bond is sold at a price higher than the face value.
6. Interest Rate: The periodic payment made to the bondholder, expressed as a percentage of the face value.
7. Amortization: The process of gradually reducing the discount or premium over the life of the bond.
8. Bond Issue Costs: The expenses incurred by the company when issuing the bond, such as underwriting fees and legal fees.
9. Discounts and premiums must be amortized over the life of the bond.
10. Bond issue costs must be recorded as an expense.