Wednesday, April 13, 2016



Corporations can raise funds by issuing common stock, preferred stock, long-term bonds or notes. The board of directors is responsible for choosing financing options. A great number of factors influence financing options such as the ability to raise funds, interest rates, tax considerations, and investor income return expectations. The type and mix of securities issued have an important effect on net income and earnings per share.

Each time a corporation issues a bond, a contract, known as the bond or trust indenture, is executed. The principal or face value of the bond, when interest payments are due and the interest rate are stated in the bond indenture. Bonds differ by the following characteristics: transferability of ownership, issuance and maturity dates, conversion provisions, redemption rights, and whether they are secured or not.

Present value is used for both financial analysis and to make business decisions. The concept of present value indicates that the value of a dollar today is not the same as the value of a dollar in the future. When a bond is issued two obligations arise: 1) periodic interest payments and 2) paying the the face amount of the bond at maturity. The selling price of a bond is determined by the present value of the combination of these two obligations.

The interest rate of a bond is stated in the bond indenture. That interest rate, known as contract or coupon rate, is often different from the prevailing market interest rates on the day the bond is issued. When the market or effective rate is higher than the coupon rate of the bond, the bond will be sold at a discount. When the market or effective rate is lower than the coupon rate, the bond will be sold at a premium. Bonds are rarely sold at their face value due to interest rate changes.

Bonds can be issued at face value, at a discount, or at a premium. When bonds are issued at face value, cash is debited and bonds payable credited. When bonds are issued at a discount, the discount on bonds payable account is debited for the amount of the discount. When bonds are issued at a premium, the premium on bonds payable account is credited for the amount of the premium. The present value of a bond is determined by adding the present value of the face value of the bond and the present value of its interest payments. The present value can be calculated using formulas, present value charts, financial calculators or computer programs.

The bond premium or discount is amortized to interest expense until the bond is redeemed or matures. There are two amortization methods: the straight-line method and the interest method. The straight-line method amortizes identical interest expenses to each period. The interest method uses a constant rate of interest. The amortization of premiums decreases interest expense, while the amortization of discounts increases interest expense.

Bond sinking funds are designed for the purpose of being able to meet debt obligations when they mature. Cash in these funds is invested in income producing securities. The income earned from investments and cash deposits are managed so that it will equal the amount due at maturity. A company has the option to manage its own bond sinking fund or appoint a trustee.

Appropriations for bonded indebtedness restrict a company's ability to pay dividends to shareholders. It requires that part of retained earnings be set aside for the repayment of bonds. Appropriations do not have a direct relationship to the bond sinking fund. Whenever an appropriation is made, Retained Earnings is debited and Appropriation for Bonded Indebtedness credited.

Bonds are redeemed most commonly when the market rate of interest declines after they have been issued. A company can usually realize a saving by redeeming its bonds and issuing new bonds with lower interest rates. Only callable bonds have the feature which allows the company to redeem them at a stated price within a specific time period. All other bonds can be purchased on the open market. It is very unlikely, however, that an entire issue can be purchased in this manner.

When a company is able to redeem bonds at a price above the carrying amount, a loss is incurred. This requires an entry that debits Bonds Payable and a Loss on Redemption of Bonds, and credits Cash. If any unamortized premium remains, this amount must also be debited. Unamortized premiums increase the cash payment required for bond redemptions. If a bond is redeemed at a price below the carrying amount, a gain has been realized. The Gain on Redemption of Bonds account is credited in such circumstances.

Bonds payable are shown as long-term balance sheet liabilities, unless they mature in a year or less. If current assets are expected to be used to retire the bonds, a Bonds Payable account should be listed in the current liability section. If the bonds are to be retired and new ones issued, they should remain as a long-term liability. All bond discounts and premiums also appear on the balance sheet.

Different bond issues should be maintained in separate accounts. When a Bonds Payable account is present on the balance sheet, it can be broken down into different issues or consolidated into a single balance. In the latter case, a schedule or note should disclose the details of the bond issues. It is also customary to provide a description of bonds issued in financial statements. The effective interest rate, maturity date, terms, and sinking fund requirements are commonly indicated in accompanying notes to financial statements.

Investments in bonds or notes should be listed under investments in the balance sheet. They should be kept separate from marketable securities. Businesses commonly invest in bonds because they have idle funds available. Corporate bonds can be purchased through a broker or directly from the issuing company. Purchasing from a company is cheaper because commission fees are absent.

Information on bonds can be obtained from the financial section of most major newspapers. Bond interest rates, volume of sales, closing price, the low and high price of the day, and the maturity date can all be found. Prices of bonds are quoted as a percentage of a bond's face value. The cost method is recommended when recording the purchase of a bond. All transaction fees and commissions should be included in the price of the purchase.

When bonds are purchased between interest payments, it is customary to pay the accrued interest to the seller. This accrued interest paid to the seller is debited to the Interest Income account when bonds are initially acquired. As interest payments are received, the Interest Income account is credited. At the end of a fiscal year, an adjusting entry is made for any accrued interest.

When the investing company sell a bond, it records a selling price net of all transaction costs and commissions. The seller also records any accrued interest. The first step in recording the sale of a bond requires one to determine the appropriate amount of the amortization of a discount or a premium. This is necessary to calculate the amount of gain or loss realized from the sale of the investment.


If a discount has been amortized in the current year, it is subtracted from the carrying value of the bond. A premium is added to the carrying amount of the bond. When the proceeds of a sale are greater than the ending carrying amount of the bond, a gain has been realized. A loss is realized when the proceeds of a sale are less than the ending carrying amount.