11. Bonds

Question 1

How do you calculate the gain or loss on retirement of debt?

Answer 1

To calculate the gain or loss, reverse the entry for the issuance of the bonds, and plug the gain or loss:

Dr. Bonds Payable (face)

Dr. Premium (unamortized as of retirement date)

Dr. Loss (plug)

Cr. BIC (unamortized as of retirement date)

Cr. Discount (unamortized as of retirement date)

Cr. Cash (amount to retire)

Cr. Gain (plug)

In other words, to calculate the amount of gain or loss:

1. Calculate the net carrying value (NCV) of the bonds at the date of retirement. NCV = face value + unamortized premium (or - unamortized discount ) - unamortized bond issuance costs
2. Subtract the net carrying value from the cash paid to retire the debt. The difference is gain or loss.

Example: On June 30, 2013, Sell Co. is paying $245,000 to retire $250,000 of 15-year bonds it issued on June 30, 2008 with a $3,000 discount and $1,500 of bond issuance costs. Since five years have elapsed since issuance, two-thirds of the discount and BIC ($2,000 and $1,000, respectively) remain unamortized. Therefore, net carrying value of the bonds at retirement is $250,000 - $2,000 - $1,000 = $247,000. NCV minus the cash paid to retire ($247,000 - $245,000) equals a gain of $2,000.

Dr. Bonds Payable (face) $250,000

Cr. BIC (unamortized as of retirement date) $1,000

Cr. Discount (unamortized as of retirement date) $2,000

Cr. Cash (amount to retire) $245,000

Cr. Gain (plug) $2,000

Question 2

What’s the difference between term bonds and serial bonds?

Answer 2

With term bonds, the principal is due in one lump sum at the end of the term.

With serial bonds, the principal is paid in installments throughout the term.

Question 3

When the effective interest method is used to amortize bond interest, what’s the difference between interest payable and interest expense?

Answer 3

Interest payable is the face value times the stated rate on the coupon. Interest expense is the carrying value times the effective rate.

Example: BeggerCo issues $100,000 of 10-year bonds at 10%. The bonds pay interest annually. Each year, interest payable is $10,000, which is face value ($100,000) times the stated rate (10%). And each year, the company pays $10,000 cash to bond holders.

But when BeggerCo issued the bonds, it sold them at a premium of $10,000 (i.e. it collected $110,000). Therefore, BeggerCo is actually paying an effective interest rate of 9% ($10,000 in annual interest for $110,000 in borrowed cash).

Because BeggarCo is amortizing the premium, the carrying value of the bond (face value - premium amortization) decreases each year. Therefore, interest expense (carrying value x effective rate) decreases each year.

Note that if BeggarCo was amortizing a discount, the carrying value of the bond (face value + discount amortization) would increase each year. Therefore, interest expense (carrying value x effective rate) would increase each year.