Bonds Payable: A Complete Guide to Bond Accounting for Accounting Students

What Bonds Are and Why Companies Issue Them

A bond is a long-term debt instrument — essentially a formal loan where the borrower (the bond issuer) promises to pay the lender (the bondholder) periodic interest payments and to repay the face amount of the bond at a specified maturity date. Companies issue bonds to raise large amounts of capital from many investors simultaneously, often at lower interest rates than they could obtain from a single bank loan.

From the issuer's perspective, bonds payable appear as long-term liabilities on the balance sheet. The accounting for bonds involves three primary questions: at what price was the bond issued (which depends on market interest rates at the time of issue), how is interest expense recognised over the life of the bond, and how is the bond removed from the balance sheet when it matures or is retired early?

Bond Pricing: Why Bonds Trade at Premiums and Discounts

The price at which a bond is issued — or subsequently trades — is determined by the present value of its future cash flows, discounted at the current market interest rate. This creates an inverse relationship between interest rates and bond prices: when market interest rates rise, bond prices fall; when market rates fall, bond prices rise.

If a bond has a stated interest rate (also called the coupon rate) equal to the current market rate, it sells at par — exactly its face value. If the stated rate is higher than the current market rate, the bond is more attractive than newly issued bonds, so investors bid up the price — the bond sells at a premium. If the stated rate is lower than the current market rate, investors require a discount to accept the lower interest payments.

Example: A company issues a $100,000, 5-year bond with a 6 percent coupon rate (annual payments of $6,000). If the market rate is also 6 percent, the bond sells for exactly $100,000. If the market rate is 8 percent, the bond must be priced to yield 8 percent — the present value of $6,000 per year for 5 years plus $100,000 at maturity, discounted at 8 percent, which is approximately $92,016. The bond sells at a discount of $7,984.

The Effective Interest Method

Under GAAP, interest expense on bonds must be recognised using the effective interest method when the results differ materially from the straight-line method. The effective interest method applies a constant effective interest rate to the bond's carrying value each period, producing an interest expense that changes each period as the carrying value amortises toward face value.

For a discount bond: The carrying value starts below face value and increases toward face value over the life of the bond. Interest expense exceeds cash interest paid each period, with the difference representing the discount amortisation. For a premium bond: The carrying value starts above face value and decreases toward face value. Cash interest paid exceeds interest expense each period, with the difference representing the premium amortisation.

Building an Amortisation Table

An amortisation table tracks the carrying value of the bond and the interest expense each period. For the discount example above (face value $100,000, coupon 6%, market rate 8%, 5 years, issue price $92,016):

Year 1: Interest expense = $92,016 × 8% = $7,361. Cash paid = $100,000 × 6% = $6,000. Discount amortised = $7,361 − $6,000 = $1,361. Carrying value at end of year 1 = $92,016 + $1,361 = $93,377.

Year 2: Interest expense = $93,377 × 8% = $7,470. Cash paid = $6,000. Discount amortised = $1,470. Carrying value = $93,377 + $1,470 = $94,847. And so on until the carrying value reaches $100,000 at maturity.

Practise building amortisation tables with bond accounting practice questions on PrepQBank.

Early Retirement of Bonds

When a company retires bonds before their maturity date, it recognises a gain or loss equal to the difference between the reacquisition price (what it pays to retire the bonds) and the carrying value at the retirement date. If it costs more to retire the bonds than their carrying value, a loss is recognised. If it costs less, a gain is recognised. These gains and losses typically appear as non-operating items on the income statement.