COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: Bonds Payable

Learning Outcomes:
1. State the initial and subsequent measurement of bonds payable.
2. Account for compound financial instruments.

Core Value/Biblical Principles:

Deuteronomy 23:19-20 ESV
“You shall not charge interest on loans to your brother, interest on money, interest on food, interest on anything that is lent for
interest. You may charge a foreigner interest, but you may not charge your brother interest, that the Lord your God may bless
you in all that you undertake in the land that you are entering to take possession of it.”

Learning Activities and Resources:

Investors buy bonds because:
• They provide a predictable income stream. Typically, bonds pay interest twice a year.
• If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to
preserve capital while investing.
• Bonds can help offset exposure to more volatile stock holdings.

Companies, governments, and municipalities issue bonds to get money for various things, which may include:
• Providing operating cash flow
• Financing debt
• Funding capital investments in schools, highways, hospitals, and other projects

Introduction:
One source of financing available is issuance of long‐term bonds. Bonds represent an obligation to repay a
principal amount at a future date and pay interest, usually on a semi‐annual basis. Unlike notes payable, which
normally represent an amount owed to one lender, a large number of bonds are normally issued at the same
time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior
to their maturity.

Body:

BONDS PAYABLE
Bonds are long-term debt instruments similar to term loans and notes except that they are usually
offered to the public and sold to many investors.
Bond indenture is the contractual arrangement between the issuer and the bondholders. It contains
restrictive covenants intended to prevent the issuer from taking actions contrary to the interests of the
bondholders. Trustee (often a bank) is appointed to ensure compliance.

Bond Indenture (Trust Indenture, Deed of Trust) may specify the following:
1. Rights and Duties of Bondholders and Issuer
a. Call Provision - the issuer’s right to call the bonds (repurchase and retire the debt security),
before scheduled maturity.
b. Redemption Right – the holder’s right to redeem the bonds before scheduled maturity.

2. Restriction and Requirements on the Issuer

a. Sinking Fund
b. Financial Ratios
c. Restriction on dividends available to the issuer’s shareholders
d. Restriction on incurrence additional obligations
e. Appointment of independent trustees
f. Authorized amount

3. Interest rate, Payment date(s), and Maturity Date(s)

A bond certificate is a legal document describing the indebtedness of a borrower and the terms under which
that indebtedness will be paid back to the investor. The entity that issues a bond certificate is referred to as
the issuer. The rate of interest to be paid on the borrowed funds.

ISSUANCE OF BONDS
1. Underwriting – bonds sold through underwriters (investment banker) who agrees on the price of
the bond, pays the issuer, and then resells the bonds to other investors at a higher price.
2. Auction
3. Direct placement with investors

TYPES OF BONDS
• As to maturity
1. Term bonds – bonds that mature on a single date.

2. Serial bonds – bonds that have series of maturity dates. These bonds are payable in installments.

3. Extendible and Retractable bonds – bonds that have more than one maturity date permitting
investors to choose the maturity dates that meet their needs.
a. Extendible bonds – bonds that give holders the right to extend the initial maturity to a
longer maturity date.
b. Retractable bonds – bonds that give holders the right to advance the return of principal
to an earlier date than the original maturity.

• As to recording point of view and payment of interests

4. Registered bonds – bonds issued in the name of the holder (owner). Interests are paid directly to
the holder. When the holder sells registered bonds, the bond certificate must be surrendered and
a new certificate is issued.
5. Coupon (bearer) bonds – bonds that can be freely transferred and have a detachable coupon for
each interest payment.
6. Zero-coupon bonds (strip bonds or deep-discount bonds) – bonds that do not pay periodic
interests. Principal and compounded interests are due only at maturity date.
7. Income bonds – bonds that pay interest only if the issuer earns profits.
8. Participating bonds – bonds that participate in excess earnings of the issuer as defined in the
indenture.
9. Indexed bonds (purchasing power bonds) – bonds that pay interest that is indexed to a measure
of general purchasing power.
10. Inflation-linked bonds (Treasury Inflation Protected Securities ‘TIPS’) – bonds that provide
protection against inflation in that the principal is increased by the change in inflation over a
period.

• As to security and risk

11. Mortgage bonds – bonds secured by real property.
12. Collateral trust bonds – bonds secured by the issuer’s financial assets or the issuer’s own equity
instruments which are deposited and held by a trustee for the bondholders.
13. Asset-backed securities – bonds based on underlying pools of assets.
14. Subordinated bonds (subordinated debentures) – bonds that normally have a higher yield than
secured bonds. They are subordinated (inferior) to the claims of other general creditors, secured
parties, and parties with priorities in bankruptcy.
15. Debenture bonds – long-term bonds not secured by specific property.
16. Junk bonds – bonds that are very high-risk, high-yield securities issued to finance leveraged
buyouts and mergers. They are issued by troubled companies.
 • As to right of redemption
17. Callable bonds – bonds that contain call provisions giving the issuer thereof the right to redeem
the bonds prior to their maturity date.
18. Convertible bonds – bonds that give the holder thereof the option of exchanging the bonds for
shares of stocks of the issuer.

• As to issuer
19. Corporate bonds – bonds issued by private companies.
20. Government Bonds – bonds issued by a government and backed by its full faith and credit.

• As to currency
21. International bonds –
a. Foreign bonds – bonds denominated in the currency of the nation in which they are sold.
b. Euro bonds – bonds denominated in a currency other than that of the nation where they
are sold.
22. Foreign currency bonds - – bonds issued by a foreign entity in a domestic market. Foreign bonds
are denominated in the domestic market’s currency and are regulated by the domestic market
authorities.

Examples of foreign bonds:

• Samurai bonds – yen-denominated bonds issued in Japan by a foreign entity.
• Kangaroo bonds or Matilda bonds – Australian dollar-denominated bonds issued in Australia
by a foreign entity.
• Maple bonds – Canadian dollar-denominated bonds issued in Canada by a foreign entity.
• Matador bonds – Euro-denominated bonds (Spain’s currency is Euro) issued in Spain by a
foreign entity.
• Bulldog bonds – British pound-denominated bonds issued in the British market by a foreign
entity.
• Yankee bonds – US dollar-denominated bonds issued in the US market by a foreign entity.

c. Global bonds – bonds that are issued in several

ACCOUNTING FOR BONDS

Bonds are accounted for in much the same way as notes and loans payable. However, bonds normally
are long-term, bear interest, issued at a premium or discount, and entail transaction (issue) costs.

Cash proceeds (Carrying Effect of Amortization on

EIR vs. NR
Amount) vs. Face Amount Interest Expense
Discount CP(CA) < FA EIR > NR Int. Expense > Int. Paid
Premium CP(CA) > FA EIR < NR Int. Expense < Int. Paid

ILLUSTRATION 1: Bonds issued at a premium

On January 1, 20x1, ABC Co. issued 1,000, P1,000, 12%, 3-year bonds for P1,049,737. Principal is due at
maturity but interest is due annually every year-end. The effective interest rate is 10%.

01/01/20x1 Cash 1,049,737

Bonds Payable 1,000,000
Premium on bonds payable 49,737

s
Subsequent Measurement
Date Interest Payments Interest Expense Amortization Present value
01/01/x1 1,049,737
12/31/x1 120,000 104,974 15,026 1,034,711
12/31/x2 120,000 103,471 16,529 1,018,182
12/31/x3 120,000 101,818 18,182 1,000,000

12/31/20x1 Interest Expense 104,974

Premium on bonds payable 15,026
Cash 120,000

12/31/20x2 Interest Expense 103,471

Premium on bonds payable 16,529
Cash 120,000

12/31/20x3 Interest Expense 101,818

Premium on bonds payable 18,182
Cash 120,000

Bonds Payable 1,000,000

Cash 1,000,000

ILLUSTRATION 2: Bonds issued at face amount

On January 1, 20x1, ABC Co. issued 10%, P1,000,000 bonds at face amount. Principal is due at maturity but
interest is due annually every year-end.

Case 1: No Transaction Costs

01/01/20x1 Cash 1,000,000

Bonds Payable 1,000,000

12/31/20x1 Interest Expense 100,000

Cash 100,000

12/31/20x2 Interest Expense 100,000

Cash 100,000

12/31/20x3 Interest Expense 100,000

Cash 100,000

Bonds Payable 1,000,000

Cash 1,000,000

Case 2: With Transaction Costs

ABC Co. paid commission of P48,037.

Initial Measurement:
Bonds Payable 1,000,000
Bond Issue Costs (48,037)
Carrying Amount of Bonds, 01/01/20x1 951,963

01/01/20x1 Cash 951,963

Bond Issue Costs 48,037
Bonds Payable 1,000,000
Trial and Error at 12%
Future Cash flows PV Factors Present value
Principal 1,000,000 PV of 1 @12%, n=3 711,780
Interest 100,000 PVOA of 1 @12%, n=3 240,183
TOTAL 951,963

Subsequent Measurement
Date Interest Payments Interest Expense Amortization Present value
01/01/x1 951,963
12/31/x1 100,000 114,236 14,236 966,199
12/31/x2 100,000 115,944 15,944 982,143
12/31/x3 100,000 117,857 17,857 1,000,000

12/31/20x1 Interest Expense 114,236

Bond Issue Costs 14,236
Cash 100,000

12/31/20x2 Interest Expense 115,944

Bond Issue Costs 15,944
Cash 100,000

12/31/20x3 Interest Expense 117,857

Bond Issue Costs 17,857
Cash 100,000

Bonds Payable 1,000,000

Cash 1,000,000

ILLUSTRATION 3: Bonds issued at a discount – with transaction costs

On January 1, 20x1, ABC Co. issued 1,000, P1,000, 10%, 3-year bonds for P951,963. Principal is due on
December 31, 20x3 but interest is due annually every year-end. In addition, ABC incurred bond issue costs of
P44,829. The effective interest rate is 12% before adjustment for bond issue costs and 14% after adjustment
for bond issue cost.

Initial Measurement:
Issue price before adjustment 951,963
Bond Issue Costs (44,829)
Carrying Amount of Bonds/ Net Issue Price 907,134

Subsequent Measurement
Date Interest Payments Interest Expense Amortization Present value
01/01/x1 907,134
12/31/x1 100,000 126,999 26,999 934,133
12/31/x2 100,000 130,779 30,779 964,912
12/31/x3 100,000 135,088 35,088 1,000,000

If the bond issue costs are not added to the bond discount, the amortization shall be allocated to the bond
issue costs and the discount based on their outstanding balance:
Outstanding Allocation of
Fraction
12/31/20X1 balance Amortization
Discount on Bonds Payable 48,037 48,037/92,866 13,966
Bond issue costs 44,829 44,829/92,866 13,033
92,866 26,999
 Bond issue costs added to Discount on Bond issue costs not added to Discount
Date
Bond Payable on Bond Payable
Cash 907,134
Cash 907,134
Discount on BP 48,037
01/01/20x1 Discount on BP 92,866
Bond Issue Costs 44,829
Bonds Payable 1,000,000
Bonds Payable 1,000,000
Interest Expense 126,999
Interest Expense 126,999
Cash 100,000
12/31/20x1 Cash 100,000
Discount on BP 13,966
Discount on BP 26,999
Bond Issue Costs 13,033

ILLUSTRATION 4: Straight-line Method vs Effective Interest Method

Use the same information in Illustration 3, except ABC Co. incorrectly used the straight-line method instead of
effective interest method to amortize the discount.

Requirements: Determine the effects of error on the following:

1. Carrying amount of bonds on Dec. 31, 20x1
2. Profit for 20x1
.
Erroneous Amortization using Straight-Line Method:
Face Amount 1,000,000
Cash Proceeds (951,963)
Discount on Bonds Payable 48,037
Divide by: Term of bonds (in years) 3__
Annual Amortization (SLM) 16,012

Interest payment (1M x 10%) 100,000

Annual amortization 16,012
Interest expense under SLM 116,012

Carrying Amount, 01/01/20x1 951,963

Annual amortization 16,012
Carrying Amount, 12/31/20x1 967,975

Amortization using Effective Interest Method:

Date Interest Payments Interest Expense Amortization Present value
01/01/x1 951,963
12/31/x1 100,000 114,236 14,236 966,199

Requirement 1: Effect on Carrying amount of bonds on Dec. 31, 20x1

Carrying Amount, 12/31/20x1 (using SLM) 967,975
Carrying Amount, 12/31/20x1 (using EIM) 966,199
Difference- overstatement under SLM 1,776

Requirement 1: Effect on Profit

20x1 Interest Expense (using SLM) 116,012
20x1 Interest Expense (using EIM) 114,236
Difference- understated under SLM 1,776
ISSUANCE OF BONDS IN BETWEEN INTEREST DATES
When bonds are issued in between interest dates, any accrued interest prior to the issuance date is
sold to the investor together with the bonds.
Any accrued interest charged to an investor should not be included in the carrying amount of the
bond but rather credited to interest expense or interest payable.
Moreover, the net interest expense recognized during the period should represent only the post-
issuance interest expense.

ILLUSTRATION 5: Issuance of bonds in between interest payment dates

On April 1, 20x1, an entity issues bonds with face amount of P5,000,000 for P5,415,183, including accrued
interest. The bonds are dated January 1, 20x1 and pay annual interest of 14% every December 31. The effective
interest rate is 12%

Requirements:
1. Compute for the initial carrying amount of the bonds.
2. Provide the entry on April 1, 20x1 to record the issuance of the bonds.
3. Compute for the interest expense in 20x1.

Requirement (a):
Issue price 5,415,183
Accrued interest (5M x 14% x 3/12) (175,000)
Carrying amount - 4/1/x1 5,240,183

Requirement (b):
04/01/20x1 Cash 5,415,183
Bonds payable 5,000,000
Premium on bonds payable 240,183
Interest expense (or Interest payable) 175,000

Requirement (c): using PRT

(5,240,183 x 12% x 9/12) = 471,616

ISSUE PRICE OF BONDS

The issuer may want to estimate the issue price of a bond under a specified current market rate. The
estimated issue price is simply computed as the present value of the future cash flows of the bonds discounted
at a specified effective interest rate.

ISSUE PRICE OF BONDS = Present Value of future cash flows; or

Future Cash Flows x PV Factor

ILLUSTRATION 6: Issue price

ABC Co. plans to issue 12%, 3-year. P1,000,000 bonds dated January 1, 20x1. Principal is due at maturity, but
interest is due annually. The current market rate is 10%.

Case 1: ABC plans to issue the bonds on January 1, 20x1. How much is the estimated issue price?
 Future Cash Flows PV @ 10%, n=3 PV Factors Present value
Principal 1,000,000 PV of P1 0.751315 751,315
Interest 120,000 PVOA of P1 2.486852 298,422
1,120,000 1,049,737

Case 2: ABC plans to issue the bonds on April 1, 20x1. How much is the estimated total proceeds from issuance?

Date Interest Payments Interest Expense Amortization Present value

01/01/x1 1,049,737
04/01/x1 30,000 26,243 3,757 1,045,981

Issue Price at 04/01/20x1 1,045,981

Add: Accrued Interest Sold 30,000___
Total proceeds from issuance 1,075,981

Life Application:
The type of bonds that might be right for you depend on several factors, including your risk tolerance, income
requirements and tax situation.
A good bond allocation might include each type -- corporate, federal, and municipal bonds -- which will help
diversify the portfolio and reduce principal risk. Investors can also stagger the maturities to reduce interest-
rate risk.
Diversifying a bond portfolio can be difficult because bonds typically are sold in 1,000 increments, so it can
take a lot of cash to build a diversified portfolio.
Instead, it’s much easier to buy bond exchange-traded fund (ETF). These funds can provide diversified
exposure to the bond types you want, and you can mix and match bond ETFs even if you can’t invest a large
amount at once.

Summary:
• Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
• Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-
versa.
• Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

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References: INTERMEDIATE ACCTG 2 [by: Millan, Zeus Vernon B. (2021)]
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/long-term-liabilities/bonds-
payable
https://www.nerdwallet.com/article/investing/how-to-buy-bonds
https://www.investopedia.com/terms/b/bond.asp