Page 599 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond
Interest Payable.
The entry required on 2011 June 30, when the full six months' interest is paid, is:

2011
June 30 Bond Interest Expense ($100,000 x 0.12 x 1,000
(1/12)) (-SE)
Bond interest payable (-L) 5,000
Cash (-A) 6,000
To record bond interest payment.
This entry records USD 1,000 interest expense on the USD 100,000 of bonds that were outstanding for one
month. Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to
them.
Bond prices and interest rates

The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a
premium. The amount a bond sells for below face value is a discount. A difference between face value and issue
price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the
bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on
bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that
investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate. Firms state this
rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each

interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the
Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the
supply of, and demand for, money.
Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are
actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a
bond issue is set at 12 per cent. If the market rate is equal to the contract rate, the bonds will sell at their face value.
However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. As shown

in Exhibit 119, if the market rate is lower than the contract rate, the bonds will sell for more than their face value.
Thus, if the market rate is 10 per cent and the contract rate is 12 per cent, the bonds will sell at a premium as the
result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will
sell for less than their face value. Thus, if the market rate is 14 per cent and the contract rate is 12 per cent, the
bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate
unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the
market rate of interest on their investment.
Computing long-term bond prices involves finding present values using compound interest. The appendix to
this chapter explains the concepts of future value and present value. If you do not understand the present value

concept, read the appendix before continuing with this section.
Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The
price investors pay for a given bond issue is equal to the present value of the bonds. To compute present value, we
discount the promised cash flows from the bonds—principal and interest—using the market, or effective, rate. We
use the market rate because the bonds must yield at least this rate or investors are attracted to alternative
investments. The life of the bonds is stated in interest (compounding) periods. The interest rate is the effective rate

600