Explain how bonds payable are accounted for
The idea
A bond is recorded at issuance at the proceeds received, which equals the present value of its payments at the market rate on that date. If the coupon is below the market rate the bond is issued at a discount and the carrying amount rises toward par over the life; above it, at a premium, and the carrying amount falls. Interest expense is the carrying amount multiplied by the market rate at issuance, not the coupon paid, so a discount bond reports interest expense above its cash coupon. On early redemption the difference between the price paid and the carrying amount is a gain or loss in income.
A practice question
At what amount is a bond initially recorded?
- Its par valueWhy not: Par is what will be repaid at maturity, not necessarily what was received. A bond issued at a discount raises less than par and is recorded at less.
- The proceeds received — correct
- The total of all coupon paymentsWhy not: That is the undiscounted interest over the life, which is not a liability at inception and ignores the principal entirely.
The proceeds equal the present value of its payments at the market rate. The market decides the price and that price is what the liability is recorded at; par is the amount repayable, not necessarily the amount received.
A harder one
How does interest expense compare with the cash coupon for a bond issued at a discount?
- Interest expense exceeds the cash coupon — correct
- Interest expense equals the cash couponWhy not: They coincide only for a bond issued at par. A discount means the effective rate exceeds the coupon rate.
- Interest expense is below the cash couponWhy not: That is the premium case. A discount was given because the coupon was too low, so the true cost is higher than the coupon suggests.
The discount is amortised into expense. The effective rate applied to the carrying amount exceeds the coupon rate applied to par, and the excess raises the carrying amount toward par.
The hardest tier
A company redeems bonds carried at 980 for a cash price of 1015. What is recorded?
- A gain of 35Why not: The right size, the wrong direction. Paying 1,015 to settle something carried at 980 costs the company 35.
- A loss of 35 — correct
- No gain or loss, since the bonds are retiredWhy not: Retirement is exactly when the difference crystallises. The liability leaves at 980 and the cash leaves at 1,015.
Paying more than the obligation is carried at is a loss, and it runs through income in the period of redemption.
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