A common way for companies to raise capital is by issuing bonds to investors. When a company issues a bond, it's essentially borrowing money from investors who receive periodic interest payments until the company redeems or repays the debt. Issuing bonds requires the company to reflect the liability and payments of interest in its financial statements. Understanding the necessary accounting entries the company will make provides invaluable insight into how corporate bonds work.
1. Record the initial bond issue on the company's books. When a company issues a bond, it must record a liability since it has an obligation to repay the investor at some point. For example, assume a firm issues a $100,000 bond on January 1, 2011 that pays annual interest of 10 percent, with the principal balance due at the end of five years. The initial journal entry on the date of issuance requires a debit entry of $100,000 to its cash account, and a credit entry of the same amount to a bonds payable account.
2. Record entries for the periodic accrual of interest. During the five-year period before the company redeems the bond, it must account for the interest it has an obligation to pay to the investor. Since the bond pays annual interest of 10 percent, or $10,000 per year, the firm must record this liability on December 31, 2011. This requires a debit entry of $10,000 to interest expense, and a corresponding credit entry to the bond interest payable account.
3. Record the entries for interest payments. A separate journal entry is necessary at the time the company sends the interest payment to the bond investor. For example, assume that the terms of the bond state that the investor will receive an annual interest payment on January 31 in the year after the interest accrues. A debit entry of $10,000 must be made on that date to the bond interest payable account, and a corresponding credit entry to the cash account to reduce the company's available cash.
4. Record the entries to redeem the bond. At the end of the five-year period, the company must repay the $100,000. When it pays the investor, it eliminates the liability with a debit entry to the bonds payable account. The corresponding credit entry is made to the cash account since the company has $100,000 less in cash.
- If you invest in a corporate bond that is publicly traded, it's not necessary for you to retain it until the redemption date. Just like a stock, you can sell a bond to other investors.
- As with any investment, there is some risk involved when you purchase a corporate bond. In the event the company goes bankrupt, you may be unable to recover your principal investment. In addition, if the risk-free market rate of interest increases and exceeds the bond's rate of interest, the value of your bond investment decreases.