LO1 – Describe the nature of bonds and the rights of bondholders.
A bond is a debt security that necessitates periodic interest payments during its life as well as a future repayment of the borrowed amount. A bond indenture is the contract that binds the corporation to the bondholders; it specifies the terms with which the corporation must comply and may restrict further borrowing by the corporation. A bondholder has the rights to receive the face value of the bond at a specified maturity date in the future; to receive periodic interest payments at a specified per cent of the bond’s face value; and in some cases, to have the corporation pledge assets to protect the bondholder’s investment.
LO2 – Describe how bonds, premiums, and discounts are recorded in the accounting records and disclosed on the balance sheet.
If the bond contract interest rate is the same as the prevailing market interest rate, the bond will sell “at par”. If the bond contract interest rate is higher than the prevailing market interest rate, the bond will sell at a premium. If the bond contract interest rate is lower than the prevailing market interest rate, the bond will sell at a discount. Premiums and discounts are recorded separately from the bonds payable in the accounting records.
LO3 – Describe and calculate how bond premiums and discounts are amortized.
Premiums and discounts are amortized over the remaining life of the bonds. Under GAAP, an unamortized premium (discount) is added to (deducted from) the face value of the bond so that the liability is recorded at its carrying amount on the balance sheet.
LO4 – (Appendices) Describe and calculate the effective interest method of amortization and explain how this differs from the straight-line amortization method.
Under the straight-line amortization method, any premium or discount is written off in equal amounts over the remaining life of the bond. Under the effective interest method, the price of a bond is determined by combining the present value of the face value to be paid at maturity and interest payments made during the bond’s life. Amortization under the effective interest method is calculated by applying the market rate of interest to the carrying amount of the bonds. The difference between this interest and the actual bond contract interest paid is the amortization applicable to the current period. The effective interest method produces a constant interest rate equal to the market rate of interest on the date the bonds were issued.
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