When a company borrows money from the public through issuing bonds, the company must disclose the transaction on its financial statements in accordance with generally accepted accounting principles (GAAP). However, since bond issuances are long-term debts, there are a number of adjustments the company must make to all bond accounts until the maturity date or the date on which the company extinguishes the bonds.
Recording Bond Issuance
The first financial entry a company makes occurs at the time it issues the bonds. Companies must report the new liability to repay the principal in a bonds-payable account, which is a liability on the balance sheet. This requires a credit entry to the payable account for the principal or face amount of all bond issuances. A corresponding debit entry to the cash account is necessary to report the inflow of cash resulting from the initial bond issuances.
Accounting for Interest
Corporate bonds generally offer investors periodic interest payments at a fixed rate which the company must report each year. For example, suppose on Jan. 1, 2011, a corporation issues a five-year bond with a face amount of $100, which is the amount it repays at maturity, with an annual coupon rate (a.k.a. interest rate) of 10 percent with interest payments made annually in the month following its accrual. On Dec. 31, 2011, the company must account for the accrual of interest by crediting an interest payable account for $10 and debiting the interest expense account for the same amount. However, when the company pays the $10 to bondholders on Jan. 31, 2012, it must reduce the interest payable account with a debit entry for $10 and reduce its cash balance with a corresponding credit entry. The company will repeat this process for each of the five years.
Maturity Repayment Reporting
If the company chooses not to extinguish the bond early, it must provide the bondholder with a $100 principal payment on the bond’s maturity date. Company accountants must close out the bonds-payable account with a debit entry of $100 and a corresponding credit entry to the cash account to reflect the payment. However, the company must also make the final interest payment on the bonds, and regardless of whether it makes the interest payment when it redeems the bond, it must still account for it separately in the same way it accounts for all other interest payments during the five-year period.
Extinguishing Before Maturity
Since corporate bonds trade in the bond market, it’s possible to purchase a bond after its issuance date. However, this also means that a corporation can purchase, or extinguish, its own bonds that are available for sale in the market. When this occurs, the company will report the transaction in the same way it does for bonds held by investors to maturity, but it must also report a gain or loss on the extinguishment. This gain or loss is the difference between the balance in the bonds-payable account and the price the company pays to acquire it in the market. For example, if the company is able to purchase one of its own $100-bonds for $98, the result is a $2 gain.