Face Value Bonds: Videos & Practice Problems

Face value bonds are issued when the stated interest rate is equal to the market interest rate. For instance, if a bond offers a 10% interest rate and the market also offers 10%, the bond will be sold at its face value, which is typically $1,000. This means that the total cash received from selling the bonds will equal the face value, making it straightforward for both issuers and investors.

The concept of present value is crucial in understanding bond pricing. Present value calculations consider the time value of money, which reflects how future cash flows, such as interest payments and principal repayment, are valued today. This principle helps explain why bonds are priced at face value when the stated and market rates are equal.

When the stated rate is less than the market rate, for example, if a bond offers 8% while the market offers 10%, the bond will sell at a discount, meaning its price will be lower than the face value. Conversely, if the stated rate exceeds the market rate, such as a bond offering 12% when the market offers 10%, the bond will sell at a premium, resulting in a price higher than the face value. This relationship indicates that the bond price moves in the same direction as the stated interest rate relative to the market rate.

To illustrate the issuance of face value bonds, consider ABC Company, which issues $50,000 of 9% bonds payable maturing in 5 years. Since the stated rate of 9% matches the market rate of 9%, these bonds are sold at face value. The interest is payable semi-annually, meaning payments are made twice a year. In this case, the cash received from the bond issuance equals the face value, simplifying the accounting process.

The journal entry for this transaction involves debiting cash for $50,000, reflecting the increase in assets, and crediting bonds payable for the same amount, indicating the liability incurred. The bonds payable account will always reflect the face value of the bonds, regardless of any discounts or premiums that may apply in different scenarios.

Understanding these concepts is essential for managing bond transactions effectively, as they form the foundation for more complex bond pricing and accounting practices.

When dealing with face value bonds, calculating interest expense is straightforward. The interest expense corresponds directly to the cash amount paid for interest. For instance, if a company issues $50,000 in bonds with a 9% interest rate, the annual interest can be calculated by multiplying the principal amount by the interest rate:

Annual Interest = Principal Amount × Interest Rate

In this case:

Annual Interest = $50,000 × 0.09 = $4,500

This amount represents the yearly interest payment. However, since interest is paid semi-annually, the company will make journal entries every six months. Therefore, the semi-annual interest payment is half of the annual interest:

Semi-Annual Interest = Annual Interest ÷ 2

So:

Semi-Annual Interest = $4,500 ÷ 2 = $2,250

On July 1, after six months, the company will pay $2,250 in cash. The journal entry for this transaction will involve debiting the interest expense and crediting cash:

Journal Entry:

• Debit Interest Expense: $2,250
• Credit Cash: $2,250

This entry reflects the cash outflow for interest, which is also recognized as an expense on the income statement. The interest expense reduces the company's equity, as expenses lower net income. Thus, the interest expense of $2,250 will decrease equity by the same amount, ensuring that the accounting equation remains balanced.

In summary, for face value bonds, the interest expense is simply the cash paid for interest, calculated based on the principal and the stated interest rate, adjusted for the payment frequency. This straightforward approach simplifies the accounting process for interest payments.

Understanding the accrual of interest payments is crucial for accurate financial reporting. When a company issues bonds, it incurs interest expenses that must be recorded in its financial statements. For instance, if a company has a principal amount of $50,000 with an annual interest rate of 9%, the total yearly interest expense amounts to $4,500. Since interest is typically paid semi-annually, the interest for a six-month period would be calculated as:

Interest for 6 months = \(\frac{4,500}{2} = 2,250\)

On December 31, the company must recognize this interest expense for the period from July 1 to December 31, even though the cash payment will not occur until January 1 of the following year. This requires a journal entry to record the interest expense and the corresponding liability, known as interest payable. The entry on December 31 would include:

Debit: Interest Expense $2,250

Credit: Interest Payable $2,250

This entry reflects the accrued interest that has not yet been paid, thus increasing the company's liabilities while simultaneously reducing equity through the interest expense. The next day, on January 1, the company will pay the accrued interest, resulting in another journal entry:

Debit: Interest Payable $2,250

Credit: Cash $2,250

This transaction eliminates the liability recorded on December 31 and reflects the cash outflow. It is essential to note that the interest payable is a liability, indicating an obligation to pay, while the interest expense reduces the company's equity. Throughout this process, the accounting equation remains balanced, as increases in liabilities are matched by decreases in equity.

In summary, accurately recording interest expenses and payables is vital for maintaining clear financial records and ensuring compliance with accounting principles. Understanding the timing of these entries helps in preparing accurate financial statements and managing cash flow effectively.

Throughout the life of bonds, companies consistently record journal entries to reflect interest expenses and cash payments. For instance, interest expense is recognized semi-annually, and at the end of each year, the company pays the interest payable. This process continues until the bond reaches maturity, at which point the principal amount must be repaid.

On January 1, 2023, after five years, the company is required to repay the principal amount of $50,000. This repayment involves settling both the principal and the final interest payment. The journal entry for this transaction is straightforward: the company debits the bonds payable account to eliminate the liability and credits the cash account to reflect the cash outflow. Specifically, the entry would be:

Debit: Bonds Payable $50,000
Credit: Cash $50,000

By debiting bonds payable, the company reduces its liabilities by $50,000, indicating that it no longer owes this amount. Simultaneously, the cash account is credited, reflecting the cash payment made to bondholders. This transaction effectively closes out the liability from the company's books.

This process illustrates the fundamental accounting principles related to face value bonds. Understanding these entries is crucial as it lays the groundwork for comparing them with discounted and premium bonds in future discussions.