A principal advantage of raising, money by issuing bonds instead of stock is that interest payments are deductible in determining income subject to corporate income taxes. Dividends paid to stockholders, however, are not deductible in computing taxable To illustrate, assume that a corporation pays income taxes at a rate of 30% on its taxable income. If this corporation issues $10 million of 10% bonds payable, it will incur interest expense of $1 million per year.
This interest expense, however, wilt reduce taxable income by $1 million, thus reducing the corporation’s annual income taxes by $300,000. As a result; the after-tax cost of borrowing the $10 million is only $700,000, as follows: funds are shown in the balance sheet under the caption “Long-Term Investments,” which appears just below the current asset section As an additional attraction to investors, corporations sometimes include a conversion privilege in the bond indenture.
A convertible bond is one that may be exchanged at the option of the bondholder, for a specified number of shares of common stock. Thus, the market value of a convertible bond tends to fluctuate with the market value of an, equivalent number of shares of common stock. IIJunk Bondi” In recent years. some corporations have Issued securities that have come’ to be known as Junk bonds. This term describeS a bond issue that Involves a substantially greater risk of default than’ normal.
A company Issuing junk bonds usually has so much long-term debt that its ability to meet interest and principal repayment obligations has become questionable. To compensate bondholders for this unusual level of risk. junk bonds promise a substantially higher rate of interest than do “investment quality” bonds.
Accounting for Bonds Payable
Accounting for bonds payable closely parallels accounting for notes payable.
The accountable events for a bond issue usually are:
(1) issuance of ‘the bonds,
(2) semiannual interest payments,
(3) accrual of interest payable at the end of each. accounting period,” and
(4) retirement of the bonds at maturity.
To illustrate these events, assume that on March 1,2001, Wells Corporation issues $1 million of 12%, 20-year bonds payable,” These bonds are dated March 1,2001, and interest is computed from this date. Interest on ‘the body is payable semiannually, each September I and March 1.
If all of the bonds are sold at par value (face amount), the issuance of the bonds on March I will be recorded by the following entry Cash Bonds Pays l88ued 12% 200year bonds payable at a price of 100. 1,000,000 Entry at the issuance Every September I during the term of the bond issue, Wells Corporation must pay’ $60,000 to the bondholders ($1,000,000 X .12 X= $60,(00).
This semiannual interest payment will be recorded as shown below:
Every December 31, Wells Corporation must make an adjusting entry to record the four months’ interest that has accrued since September 1 Bond Interest Expense 60,000 Entry to record semiannual Cash 60,000 Interest payments Semiannual payment of bond Interest. Bond Interest· Expense 40,000 Bond Interest Payable To accrue bond interest payable for four months ended ·Dec. 31 · ($1.00(1,000 x .12x “112 = $40,000).· Adjusting entry at year-end-« 40,000 ‘If necessary Bond Interest Expensd 20,000 Bond Interest Payable 40,000 CashTo record semiannual Interest payment to bondholders, and to recognize two months’ interest expense accrued since year end ($1,000,000 x .12 x ~12 = $20,000).
Interest payment following the year-end adjusting entry The accrued liability for bond interest payable will be paid within a few months and therefore, is classified as a current liability. Two months later, on March t, a semiannual interest payment is made to bondholders. This transaction represents payment of the four months’ interest accrued at December 31. and of two months’ interest that has accrued since year-end. Thus the entry to record the semiannual interest payments every March 1 will be: 60,000 When the bonds mature 20 years later on March l. 2021, two entries are required: one to record the regular semiannual interest payment and a second to record the retirement of the bonds. The entry to record the retirement of the bond issue is:
Bonds Payable 1,000,000 Cash Paid face amount of bonds at ‘maturity. Redeeming the bonds 1,000,000 at the maturity date
Bonds Issued Between Interest Dates The semiannual interest dates (such as January 1
and July 1. or April 1 and October 1) are printed on the bond certificates. However bonds lie often issued between the specified interest dates. The investor is then required to pay the interest accrued to the date of issuance in addition to the stated price of the bond. This practice enables the corporation to pay a full six months’ interest on all bonds amount of $1 million is used only for purposes of illustration. As explained earlier, actual bond issues are for many millions of dollars