What are bonds payable?
Bonds payable are a form of long term debt usually issued by corporations, hospitals, and governments. The issuer of bonds makes a formal promise/agreement to pay interest usually every six months (semiannually) and to pay the principal or maturity amount at a specified date some years in the future. The agreement containing the details of the bonds payable is known as the bond indenture.
Example:
Usually public utilities issue bonds to help finance a new electric power plant, hospitals issue bonds for new buildings, and governments issue bonds to finance projects, operating deficits, or to redeem older bonds that are maturing.
For example, a profitable public utility might finance half of the cost of a new electricity generating power plant by issuing 30-year bonds. If the current market interest rate for the bonds is 4%, the cost after the income tax savings may be only 3%.
What is the effective interest rate?
The effective interest rate is the true rate of interest earned. It can also mean the market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual percentage rate (APR), and the targeted or required interest rate.
Example:
Assume that a corporation issues a Rs.1,000 bond with a stated, contractual, face, or nominal interest rate of 5%. This means that the corporation will pay exactly Rs.50 per year during the life of the bond plus the principal amount at maturity. Let's also assume that after the bonds are issued the market interest rates increase by one percentage point. As a result the 5% bond will lose some of its value because the contractual payment of Rs.50 per year is not worth Rs.1,000 when the market is paying Rs.60 per year for a similar Rs.1,000 bond. An investor will purchase the 5% bond only if the cost is low enough to yield 6% over the remaining life of the bond. In other words, the investor will pay less than the Rs.1,000 so that the effective interest rate for the remaining life of the bond will be 6%.
Where is the premium or discount on bonds payable presented on the balance sheet?
The premium or discount on bonds payable is the difference between the amount received by the corporation issuing the bonds and the par value or face amount of the bonds. If the amount received is greater than the par value, the difference is known as the premium on bonds payable. If the amount received is less than the par value, the difference is known as the discount on bonds payable.
The premium and discount accounts are viewed as valuation accounts. The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable.
The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the premium or discount account is the unamortized balance.
The premium or the discount on bonds payable that has not yet been amortized to interest expense will be reported immediately after the par value of the bonds in the liabilities section of the balance sheet. Generally, if the bonds are not maturing within one year of the balance sheet date, the amounts will be reported in the long-term or noncurrent liabilities section of the balance sheet.
Why does a bond's price decrease when interest rates increase?
A bond's price is the present value of the following future cash amounts:
- The cash interest payments that occur every six months, plus
- The lump sum cash amount that occurs when the bond matures
Typically, a bond's future cash payments will not change, but the market interest rates will change frequently. The change in the market interest rates will cause the bond's present value or price to change. For instance, if a bond promises to pay 6% interest annually and the market rate is 6%, the bond's price should be the same as the bond's maturity value. However, if the market rate increases to 7%, and an existing bond is promising to pay only 6%, the 6% bond will not be worth its face value or maturity value. For it to be sold, the price will have to be less than the maturity amount. However, if the market rates drop to 5%, an existing bond that is promising to pay 6% will be very attractive. As a result, this bond will sell for more than its maturity value.
In summary, an existing bond's price or present value moves in the opposite direction of the change in market interest rates:
- Bond prices will go up when interest rates go down, and
- Bond prices will go down when interest rates go up
Example:
Let's assume there is a Rs.1,00,000 bond with a stated interest rate of 9% and a remaining life of 5 years. This means that the bond is promising to pay Rs.4,500 at the end of each of the 10 remaining semiannual periods plus Rs.1,00,000 at the end of the bond's life. If an investor's goal is to earn 9% and the market interest rate is 9%, the investor will pay Rs.1,00,000 for the bond. However, if the market interest rates increase to 10%, any investor will be able to earn Rs.5,000 semiannually on a Rs.1,00,000 investment. Obviously, the 9% bond (paying only Rs.4,500 semiannually) will not get sold for Rs.1,00,000. To get sold, the price will have to be less than Rs.1,00,000.
For an investor to buy the 9% bond in a 10% market, the bond's price will have to drop to an amount that will provide the buyer with a yield to maturity of 10%. Let's assume that the present value calculation indicates that the price would have to be Rs.96,000. The cash payments of Rs.4,500 every six months for five years on the Rs.96,000 cash investment plus the gain of Rs.4,000 (receiving Rs.1,00,000 in 5 years versus the investment of Rs.96,000) will result in the required yield of 10%.
What does it mean to amortize the premium, discount and issue costs on bonds payable?
With regards to bonds payable, the term amortize means to systematically allocate the discount on bonds payable, the premium on bonds payable, and the bond issue costs to Interest Expense over the remaining life of the bonds. (Bonds are likely to mature in 10 years or more.)
The term amortize is conceptually similar to the term depreciate, except that depreciate is used when allocating the cost of a plant asset to expense.
Unless the discount, premium, and issue costs are insignificant, the amounts are to be spread to Interest Expense over the remaining life of the bond. The most precise way to amortize these is to use the effective interest rate method. A less precise method is the straight-line amortization method, which is often an acceptable alternative.
What conditions cause a discount on bonds payable?
Discount on bonds payable occurs when a bond's stated interest rate is less than the bond market's interest rate.
If a Rs.10,00,000 bond issue promises to pay interest of 8% per year and the bond market demands 8.125%, the bonds will sell for less than Rs.10,00,000. The difference between the Rs.10,00,000 of face value and the amount the bond market is willing to pay is the discount on bonds payable.
The amount of the discount is a function of (1) the number of years before the bonds mature, and (2) the difference in the bond's stated interest rate and the market's interest rate.
What is the book value of bonds payable?
The book value of bonds payable is also referred to as the carrying value of bonds payable. The book value of bonds payable consists of the following amounts, all of which are found in bond-related liability accounts:
- The face value of the bonds (which is a credit balance in the account Bonds Payable)
- The related unamortized discount (which is a debit balance in the contra-liability account Discount on Bonds Payable)
- The related unamortized premium (which is a credit balance in the adjunct-liability account Premium on Bonds Payable)
- The related unamortized bond issue costs (which is a debit balance in the contra-liability account Bond Issue Costs)
It important that the discount, premium, and issue costs are amortized properly up to the moment when the book value of the bonds is needed.
What is the face value of a bond payable?
The face value or face amount of a bond payable is the amount printed on the bond. The face value is also referred to as the par value, stated value, maturity value, principal amount, and legal amount.
The face value is used to calculate the cash interest payments required during the life of the bond, and it indicates the cash amount that must be paid at the maturity date. For example, if a corporation issues a bond payable having a face value of Rs.1,000,000 and a stated interest rate of 6% per year, it is likely that the bond issuer is obliged to pay the following:
- Rs.30,000 of interest every six months until the bond matures (Rs.10,00,000 X 6% X 6/12)
- Rs.1,000,000 at the maturity date of the bond
At the time the corporation issues a bond for cash, the long-term (noncurrent) liability account Bonds Payable will be credited with the face value of the bond. Cash will be debited for the cash received, and any difference will be recorded in one or two of the following bond-related liability accounts:
- A debit to Discount on Bonds Payable
- A credit to Premium on Bonds Payable
- A debit to Bond Issue Costs
Between the date that a bond is issued and the date that the bond matures, the discount, premium, and/or issue costs must be amortized to the account Interest Expense. On the maturity date, the maturity value will be removed when the bond issuer's Rs.10,00,000 payment is made to the one or more bondholders.
Why do bonds rarely sell for their maturity value?
The reasons why bonds rarely sell for their maturity value are:
- The interest paid is usually fixed at the interest rate that is stated on the face of the bond. As a result, the amount of interest paid each year does not change during the life of the bond.
- The market interest rate—the rate that bond buyers demand—is changing daily.
Example:
To illustrate, let's assume that a 6% bond will mature in ten years and has a maturity value of Rs.1,00,000. This means that the bondholders will be receiving Rs.6,000 in interest in each of the ten years. If there is a day when the bond buyers demand an interest rate of 6.2% then the bond's value on that day will be less than Rs.1,00,000. If on another day the bond buyers demand 5.9% interest, the bond's value on that day will be greater than Rs.1,00,000.
Why are bonds payable less costly than common stock?
Bonds payable are less costly than common stock because the bonds issued by a corporation contain a formal contract to pay the investor a fixed amount of interest every six months and to pay the face or principal amount when the bonds mature. The contract to pay these cash amounts to the investors makes bonds a less risky investment than common stock. Less risk for the investor means the investor will earn a smaller return—and the corporation will have a smaller cost. Some bonds might also provide collateral and some bonds might require that a sinking fund be established to set aside money to pay the bondholders when the bonds come due. These features will further reduce the investor's risk and should further reduce the corporation's cost.