Question

Describe the accounting valuation for bonds at date of issuance.

Answer 1

When a company issues bonds, it must record the amount of cash received and the corresponding liability. Recording the liability is the easiest part because the liability is always equal to the face value of the bond. To determine how much cash will be received, we need to know if the bond will sell for par value.
A bond will sell for par value if the stated interest rate is equal to the market rate. If that is the case, the company will receive cash equal to the face value of the bond.
Example #1
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is also 8%. Record a journal entry for the issuance of the bonds.
Since the stated interest rate and the market rate are the same, these bonds will be sold at face value. The journal entry for a par value bond, like this one, is fairly simple. The accounts will be Cash, to record the increase in cash, and the liability will be called Bonds Payable. The amount of the entry is the face value of the bond.

Bond Discounts
When the market rate is not the same as the stated or contract rate, the bond payable and cash will not be the same. If the market rate is higher than the stated rate, that means people are not willing to pay as much for the bonds. Either there is risk associated with the company or there are better investments elsewhere. In order to entice the public to buy the bonds, the company must offer a discount on the bonds. The company will receive less cash than face value. The difference between the face value of the bond and the cash received is called the bond discount or discount on bonds payable.
Example #2
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 10%; therefore, the bonds will only bring $350,152. Record the journal entry for the issuance of the bonds.
In this case, the market rate is higher than the stated rate which means that the bonds will sell for less than face value.If the public can get 10% elsewhere, why would they pay full price to only receive 8%? They wouldn’t. So while the bond will pay $400,000 at the end of the 10-year term, the bond is only worth $350,152 right now (we will discuss how you calculate that number later in the material).
The difference between the amount of cash received and the liability is called Discount on Bonds Payable. This is a contra-liability, linked to Bonds Payable. Since Discount on Bonds Payable is a contra-liability, the normal balance is a debit. This makes sense because we need something to add to Cash on the debit side to balance out the $400,000 Bond Payable.

Bond Premiums
When a company offers a bond at a higher interest rate than the market expects, the public is willing to pay more for the bonds. This causes more cash to come in than the amount of the liability. In cases like this, we say that the bond sells for a premium.
Why would a company offer a bond at a premium? This can occur when the company offers a slightly higher interest rate than the market rate or when the company is so stable that it is almost certain that the creditors will be repaid. In today’s record low interest rate environment, the public is willing to spend a bit more money up front to get a better interest rate.
When a bond sells for a premium, the amount of cash generated from the sale is higher than the liability. In order to balance the journal entry, we create an account called Premium on Bonds Payable. This is an additional liability that attaches to Bonds Payable, just like a contra-account would. However, because the normal balance in Premium on Bonds Payable is a credit balance, it is not considered a contra-liability.
Example #3
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 6%; therefore, the bonds will bring $459,512. Record the journal entry for the issuance of the bonds.
Because more cash is generated from the sale than the amount of the outstanding liability, the bonds are selling at a premium. The company will receive $459,512 in Cash but the Bond Payable is only $400,000. The amount of the premium is $59,512 (we will discuss how to calculate the premium later in the material). Cash is increasing, the Bond Payable is increasing and the Premium on Bonds Payable is increasing.