What Are Bonds Payable and How Are They Accounted For?

Bonds payable are long-term debt obligations used by corporations and governments to raise capital. They represent a formal promise by the issuer to repay borrowed money with interest over a specified period. These instruments enable organizations to raise substantial capital without diluting ownership, playing a significant role in corporate finance.

Fundamentals of Bonds Payable

Bonds payable are characterized by several core components. The “face value,” also known as par value or maturity value, represents the principal amount the issuer commits to repay on a specific future date. The “coupon rate,” or stated interest rate, dictates the annual interest payments made on the bond’s face value. These interest payments are typically made semi-annually until the bond reaches its “maturity date,” the predetermined date when the principal must be repaid to the bondholder. The issuer is the entity borrowing the money, while the bondholder is the party lending the money.

The agreement outlining the bond’s terms and conditions, including the coupon rate, payment frequency, and maturity date, is documented in a “bond indenture.” Bonds payable are classified as long-term debt obligations on a company’s balance sheet, reflecting the commitment to repay borrowed capital over an extended period.

Common Types of Bonds Payable

Bonds payable can take various forms, each with distinct features. “Secured bonds” provide collateral, meaning specific assets of the issuer back the debt, offering protection to bondholders. Conversely, “unsecured bonds,” often called debentures, are not backed by specific assets but by the issuer’s general creditworthiness. Unsecured bonds may carry higher interest rates to compensate investors for the increased risk.

“Convertible bonds” offer bondholders the option to convert their bonds into a predetermined number of the issuer’s common shares under certain conditions. “Callable bonds” grant the issuer the right to redeem the bonds before their scheduled maturity date. Issuers might exercise this option if interest rates decline, allowing them to refinance at a lower cost.

“Zero-coupon bonds” do not pay periodic interest. Instead, they are sold at a discount from their face value and mature at the full face value, with the difference representing the investor’s return. For the issuer, the payable amount effectively accumulates over time until maturity. “Registered bonds” record ownership with the issuer, while “bearer bonds” did not, allowing the holder to be the owner.

Accounting Treatment of Bonds Payable

When a company issues bonds, the initial recording depends on the relationship between the bond’s stated interest rate and the prevailing market interest rate. Bonds can be issued at face value (at par), at a premium (above face value), or at a discount (below face value). If the stated interest rate is higher than the market rate, the bond sells at a premium, meaning the issuer receives more cash than the bond’s face value. Conversely, if the stated rate is lower than the market rate, the bond sells at a discount, resulting in the issuer receiving less cash than the face value.

Interest expense on bonds payable is recognized over the life of the bond. For bonds issued at a premium or discount, this involves an amortization process. The “amortization of premium” reduces the carrying value of the bond and decreases the periodic interest expense. Conversely, the “amortization of discount” increases the carrying value and raises the periodic interest expense. The straight-line method systematically amortizes the premium or discount evenly over the bond’s life, affecting the interest expense recognized on the income statement.

Bonds payable are presented on the balance sheet as a long-term liability, typically under a “Bonds Payable” account. The carrying value of the bond, which is the face value adjusted for any unamortized premium or discount, appears on the balance sheet. If any portion of the bonds matures within one year of the balance sheet date, that portion is reclassified and presented as a current liability.

The income statement reflects the interest expense incurred on the bonds during the accounting period. On the cash flow statement, the issuance of bonds is reported as a cash inflow from financing activities, while interest payments are typically categorized as operating activities, and the repayment of the principal is a financing outflow.

Strategic Reasons for Issuing Bonds

Companies often choose to issue bonds as a strategic financing tool for several reasons.

Cost of Capital

Interest payments on bonds are generally tax-deductible for corporations, which reduces their taxable income and effectively lowers the net cost of borrowing. This tax deductibility can make debt financing more attractive than equity financing, where dividends paid to shareholders are not tax-deductible.

Retaining Ownership and Control

Issuing bonds allows companies to raise substantial capital without diluting the ownership stake of existing shareholders. Unlike issuing new stock, which introduces new owners, bonds represent a loan that does not grant bondholders any ownership rights or voting power. This enables current management and shareholders to maintain their control over the company’s operations and strategic direction.

Predictable Payments

Bonds offer predictable payments for the issuer. The interest payments are typically fixed at the time of issuance, providing clear and consistent cash outflow obligations. This predictability aids in financial planning and cash flow management, especially when compared to equity financing, where dividend payments might be more variable.

Access to Capital

Issuing bonds provides companies with access to capital from a broad base of investors, allowing them to raise large sums of money efficiently for significant projects, acquisitions, or to manage existing debt. This widespread access to capital can be more flexible than traditional bank loans, which might come with more restrictive covenants.