What Is a Bond Payable & How Is It Accounted For?

A bond payable represents a formal promise by an entity, such as a corporation, to repay borrowed money to investors. It serves as a debt instrument, allowing companies to raise capital from many investors rather than a single lender like a bank. When a company issues bonds, it borrows funds directly from investors, incurring a long-term liability. This financial tool is crucial for businesses to finance large projects, expand operations, or manage existing debt without diluting ownership. Bonds payable are recorded on the issuer’s balance sheet as a liability, reflecting the obligation to make periodic interest payments and return the principal amount at a future date.

Core Elements of a Bond Payable

A bond payable has several components defining the issuer’s obligation to bondholders. The face value, also known as par value or principal amount, is the total sum that the issuer promises to repay to the bondholder at maturity. This amount is typically $1,000.

The coupon rate, or stated interest rate, is the fixed percentage of face value the issuer pays as interest to bondholders. These interest payments are usually made semiannually. The maturity date is the future date when the bond’s principal must be repaid to bondholders. Maturities vary from short-term (under five years) to long-term (over ten years).

The issue price is the cash a company receives when it sells the bond. This price can be at par (equal to face value), a premium (above face value), or a discount (below face value), depending on the bond’s coupon rate and market interest rates at issuance. The bond’s terms and conditions, including payment schedules and any special features, are outlined in a legal document called a bond indenture.

Reasons for Issuing Bonds

Companies issue bonds for several strategic advantages. One primary reason is the ability to raise significant capital without diluting existing ownership, allowing founders and shareholders to maintain control. Bond financing often presents a lower cost of capital compared to equity, as bond interest rates can be more favorable than returns demanded by equity investors.

Predictable, fixed interest rates provide clarity for financial planning, protecting the company from fluctuations in interest rates common with variable-rate loans. Additionally, interest payments made on corporate bonds are generally tax-deductible for the issuing company. This tax deductibility reduces the net cost of borrowing, providing a tax shield that can lower the company’s overall tax liability.

Issuing bonds also offers greater financial flexibility compared to traditional bank loans, which may come with restrictive covenants. Companies can tailor bond structures, including maturities and repayment terms, to suit their specific financial needs and strategic objectives. This flexibility allows businesses to align long-term assets with long-term financing, reducing liquidity risk.

Common Types of Bonds

Companies issue various types of bonds, each with distinct characteristics. Secured bonds are backed by specific assets of the issuing company, such as property or equipment, which serve as collateral. This backing provides security to investors, potentially allowing the issuing company to offer a lower interest rate due to reduced risk. Conversely, unsecured bonds, often called debentures, are not backed by specific assets but rely on the general creditworthiness and financial strength of the issuing company. Companies with strong credit ratings often issue debentures.

Callable bonds grant the issuing company the option to repurchase, or “call,” the bonds before their scheduled maturity date. This feature allows a company to retire existing debt and potentially re-issue new bonds at a lower interest rate if market rates decline. Convertible bonds offer bondholders the choice to convert their bonds into a predetermined number of the issuing company’s common stock shares. Convertible bonds can be an attractive way to raise capital at a lower interest rate than non-convertible bonds, with the potential to convert debt into equity later.

Zero-coupon bonds do not pay periodic interest payments. Instead, they are issued at a discount to face value and mature at face value, with the investor’s return coming from the difference between the purchase price and the face value at maturity. Other classifications include fixed-rate bonds, which pay a constant interest rate throughout their life, and floating-rate bonds, where interest payments adjust based on a benchmark rate.

Accounting for Bonds Payable

Accounting for bonds payable begins at issuance, with initial recording depending on whether the bonds are sold at par, a premium, or a discount. When bonds are issued at par, the cash received by the company equals the bond’s face value. The accounting entry involves debiting cash for the amount received and crediting bonds payable for the same face value, reflecting the exchange of cash for the debt obligation.

If bonds are issued at a premium, the cash received is greater than the bond’s face value, typically because the bond’s coupon rate is higher than the prevailing market interest rate. The accounting entry debits cash for the higher amount received, credits bonds payable for the face value, and credits “Premium on Bonds Payable” for the difference. This premium account is an adjunct liability account, increasing the carrying value of the bonds on the balance sheet.

Conversely, if bonds are issued at a discount, the cash received is less than the bond’s face value, usually because the bond’s coupon rate is lower than the market interest rate. The entry debits cash for the amount received, debits “Discount on Bonds Payable” for the difference, and credits bonds payable for the face value. The discount account is a contra-liability account, reducing the carrying value of the bonds on the balance sheet.

Interest expense on bonds payable is recognized over the bond’s life. While bondholders receive cash interest payments based on the coupon rate and face value, the actual interest expense recorded considers any premium or discount. The straight-line method of amortization, commonly used for simplicity, spreads the total premium or discount evenly over the bond’s life. For a bond issued at a premium, the amortization amount is subtracted from the cash interest payment to arrive at a lower periodic interest expense. This reduces the Premium on Bonds Payable account over time.

For a bond issued at a discount, the amortization amount is added to the cash interest payment to result in a higher periodic interest expense. This increases the carrying value of the bond and reduces the Discount on Bonds Payable account over time. The effective interest method is an alternative, more precise approach that accounts for the time value of money, but the straight-line method is often used for simplicity when amounts are not material. Interest expense is typically recognized periodically, often semiannually, even if cash payment dates do not align perfectly with accounting periods, requiring accruals.

Bonds payable are presented on the balance sheet as a long-term liability, reflecting the company’s obligation to repay the principal. Any unamortized premium or discount is reported directly after the face value of the bonds, adjusting the carrying value of the debt. The carrying value of a bond, also known as its book value, is the face value plus any unamortized premium or minus any unamortized discount. As the maturity date approaches, the portion of bonds payable due within one year is reclassified from long-term to current liabilities.

On the income statement, the interest expense related to bonds payable is reported as a non-operating expense. This expense impacts the company’s earnings before taxes, providing a tax shield that reduces taxable income. The amount reported includes both the cash interest paid and the amortization of any premium or discount for the period.

Upon redemption or repayment at maturity, all premiums and discounts should have been fully amortized, meaning the bond’s carrying value equals its face value. The final accounting entry involves debiting the Bonds Payable account for its face value to remove the liability and crediting the Cash account for the same amount to reflect the repayment to bondholders. This process settles the company’s debt obligation to the bondholders.