LO 12 3 Prepare Journal Entries to Reflect the Life Cycle of Bonds v2 Principles of Accounting Financial Accounting

Company ABC issue 5% 2,000 convertible bonds with par value of $ 1,000 each. They are the convertible bonds that give the right to holders to convert to a common share at the maturity date at the conversion rate of 20. The bonds were issued to yield 12%, which is another way of saying that they were issued at par, and thus the company received the full $100,000.

However, corporate bonds often pay a higher rate of
interest than municipal bonds. Despite the lower interest rate, one
benefit of municipal bonds relates to the tax treatment of the
periodic interest payments for investors. With corporate bonds, the
periodic interest payments are considered taxable income to the
investor.

Retirement of Bonds When the Bonds Were Issued at Par

The bond types vary by features carried by the bond such as the interest rate, frequency of coupon payments, maturity date, attached warrants, and so on. Before jumping to detail, let’s understand the basic concept of the bond. The bondholders have the right to receive interest as stated on the bond certificate as well as the principal at the maturity date. Bonds are a type of debt financing that allows businesses to borrow money from investors in exchange for interest payments over a set period. Understanding how to record a journal entry for bond issuance is an important skill for any business owner.

• Likewise, with the amortization, the balance of the unamortized bond discount will be reduced throughout the life of the bond until it becomes zero at the end of bond maturity.
• Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.
• Let us calculate the PV of bond principal payment and interest component first.
• As mentioned above, as per the straight-line method, the amortization of bond premium is calculated by dividing the total interest on bonds by the total number of periods until the maturity date.

With corporate bonds, the periodic interest payments are considered taxable income to the investor. For example, if an investor receives $1,000 of interest and is in the 25% tax bracket, the investor will have to pay $250 of taxes on the interest, leaving the investor with an after-tax payment of $750. So the same investor receiving $1,000 of interest from a municipal bond would pay no income tax on the interest income.

Journal Entries for Interest Expense – Annual Financial Statements

This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected  $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them. The April 30 entry in the next year would include the accrued amount from December of last year and interest expense for Jan to April of this year. (Figure)Assume you are a newly hired accountant for a local manufacturing firm. Bondholders receive the stated rate times the principle, so they would receive $6,000.

v2 Principles of Accounting — Financial Accounting

Here’s what you need to know about recording journal entries for bond issuances. Thus, Schultz will repay $47,722 ($140,000 – $92,278) more than was borrowed. Spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20 (not to be confused with the periodic cash payment of $4,000). When a company issues bonds, they make a promise to pay interest
annually or sometimes more often.

Reverse convertible bonds allow the company to buyback the bonds or allow it to be converted to share at the maturity date. The issuer can use cash to buyback bonds otherwise they will be converted to equity share base on the conversion rate which is predetermined. Companies would issue bonds between the interest payment dates if they do not have enough funds to pay them on that date.

LO 12.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds

The same as discount bonds, the total interest shall need to divide by the total number of periods until the maturity date of the bonds in order to recognize the interest expense equally for each period. This is called the straight-line method of amortization of bond premium. When a company issues bonds and sells at the price higher than the market rate, it is called premium bonds. This means that the issued price is higher than the par value of the bonds.

Municipal Bonds

Another way to illustrate this problem is to note that total borrowing cost is reduced by the $8,530 premium, since less is to be repaid at maturity than was borrowed up front. To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. Because the bonds have a 5-year life, there are 10 interest payments (or periods). The periodic interest is an annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the tenth period.

Interest expense for the first two months was recorded in Year One with interest for the next four months recorded here in Year Two. Many companies are not able to borrow money (or cannot borrow money without paying a steep rate of interest) unless some additional security is provided for the creditor. Any reduction of risk makes a note or bond instrument more appealing to potential lenders. For example, some maxine waters loans (often dealing with the purchase of real estate) are mortgage agreements that provide the creditor with an interest in identified property. The recent downturn in the housing market has seen many debtor defaults that have led to bank foreclosures on homes across the country. Notes and bonds can also be set up to allow the debtor to choose to repay part or all of the face value prior to the due date.