When an organization requires additional funds, a common action is to borrow money from a bank. However, issuing debt securities, such as bonds, is another way organizations can borrow funds. Issuing securities is borrowing in that the organization receives cash which must be repaid to the lender at a later date.
Issuing bonds rather than entering into a loan agreement can be attractive to organizations for many reasons. Bonds allow an entity to borrow large sums at low-interest rates. They also give organizations greater freedom as bank loans can often be more restrictive. Additionally, the interest payments made for some bonds can also be used to reduce the amount of corporate taxes owed. Even with these benefits considered, governments and municipalities issue bonds more often than public or private organizations.
Government entities issue bonds to finance a variety of different projects and activities, such as:
- Operating cash flow
- Financing debt payments
- Funding capital investments in schools, highways, hospitals, and other projects.
What are bonds payable?
Bonds payable are a type of debt, varying from loans and notes. An organization will issue a bond or bonds to individuals or other entities in exchange for cash. The organization then has an obligation, recorded as bonds payable, to remit the cash received back to the bondholders at a later date, usually stated on the bond as the maturity date.
Payment schedules for bonds can differ from loans. An organization with a bond payable will commonly make periodic payments to its bondholders towards the interest owed on the bonds. Payments for the principal amount of a bond can be made at regularly prescribed intervals or the entire principal amount of the bond is paid at the date of maturity.
Interest in bonds
Similar to loans, bonds have both a principal and interest component. Interest is typically stated in the bond as a percentage of the overall bond amount. Often you will see bond interest paid semi-annually. For example, if an organization issued a $100,000 bond with a stated 5% interest rate, then the overall interest expected to be paid out on this bond annually would be $5,000. Semi-annually the bondholders would receive payments of $2,500. The interest may vary as well, based on whether the bond was sold at a premium or a discount.
Discount vs. premium
Regularly, a bond’s value is not equal to its current market price at the date of issuance. For that reason, a bond will be issued at a premium or discount. Bonds will have a stated rate of interest dictating the value of the periodic interest payments. However, market interest rates change frequently, so the interest rate stated on the bond may be different from the current interest rate at the time of bond issuance. Therefore, bonds sold below the current market value are issued at a discount while bonds issued above the current market value are at a premium.
If the interest rate stated on the face of the bond is below the current market rates, the bond is likely to be sold at a price lower than its face value to make up for the lower interest payments the buyer would receive from the market. In other words, these bonds are issued at a discount, and a bond discount will be recognized in the financial statements of the issuing organization.
On the other hand, if the interest rate stated on the face of a bond is greater than the prevailing market rate on the date of issuance, the bond will be sold at a higher price than the face value. The buyer would receive higher interest payments than what is potentially available on the current market. This is called a bond premium, and would also be recognized on the financial statements of the bond issuer.
Issuance costs
When organizations issue bonds to the market, certain fees are associated with doing so. These fees include things such as:
- Commissions
- Legal fees
- Registration fees
- Fees from underwriting, and
- Small costs like printing
The appropriate accounting treatment for issuance costs is to capitalize them upon original issuance and then expense them over the remaining life of the bond until maturity. Additionally, if bonds are paid off before their maturity date, the remaining unamortized issuance costs will be expensed as of the payoff date.
Bond payable accounting
When determining how to account for a bond, multiple aspects must be considered. First, we consider what components of the bond will need to be recorded. Second, we establish what area of the financial statements are impacted by issuing the bonds. Finally, we consider the ongoing accounting treatment.
The components of a bond to account for have been discussed earlier:
- The principal of the bond
- The interest of the bond
- The discount or premium, if applicable
The principal portion of the bond is recognized as a bond payable in the liabilities section of the balance sheet. The entry to record the bond payable is a debit to cash for the amount of the funds received and a credit to the bond payable, to be remitted to the purchaser of the bond upon maturity. The principal may be adjusted by any applicable discount or premium of the bond.
The issuance cost incurred will be accounted for based on the jurisdiction of the organization issuing the bond. If a governmental entity accounting under GASB issues the bond, the issuance cost will be expensed as incurred on the statement of net activities. If an organization following FASB standards issues the bond, the total issuance cost will be deferred and amortized over the life of the bond. The issuance cost would be recorded on the balance sheet as a liability and then expensed on the income statement as it is amortized through issuance expense over the life of the bond.
Finally, the interest expense due to the purchaser of the bond is expensed as incurred on the income statement.
Amortization of the discount or premium
The book value of a bond must be maintained in a schedule and reported on the financial statements. The book value is equal to the bonds payable principle balance adjusted by a discount or premium, if appropriate. At issuance, the book value will be the purchase price or the value stated on the face of the bond plus any premium paid or minus any discount received. Over time, the discount or premium is amortized.
In the case of a discount, an investor may pay less than the face value of the bonds when the rate that is stated on the face of the bond is lower than the interest rate in the market at that time. In this situation, investors earn a larger return on their investment because of the purchase at a reduced price. The issuing entity accounts for the amount of discount (the difference between the face value and the amount paid) in a contra liability account and then amortizes the balance of the discount over the life of the bond.
The discount amortization will increase the total amount of interest expense recorded on the income statement. In this situation, the total amount of interest expense over the life of the bond is going to be greater than the amount of interest paid to investors. The interest recognized on the income statement is interest expense related to the rate stated on the bond plus the discount amortization.
When a bond is issued at a premium, the premium amount is recorded as an additional liability and amortized over the life of the loan. The recorded interest expense is less than the statement amount as a result of the premium amortization.
Summary
As discussed, organizations can obtain cash in ways other than a conventional loan, and it is important to understand the options and their benefits. Bonds offer a unique opportunity for organizations to obtain needed funds with fewer restrictions, at potentially better rates than a loan from a bank. Bonds do, however, have additional considerations, both from a market perspective and an accounting perspective.
