Redeeming Bonds before Maturity: Videos & Practice Problems

Companies may choose to repurchase their bonds before they mature, a process known as redeeming bonds early. This decision can stem from various reasons, such as a company no longer needing the loan and wanting to stop interest payments, or taking advantage of lower interest rates. For instance, if a company initially issued bonds at a 10% interest rate and market rates have dropped to 6%, it can buy back the higher-interest bonds and reissue new ones at the lower rate, effectively reducing its interest expenses.

When a company repurchases its bonds, it does so at a price that may differ from the bonds' carrying value, which is the book value reflecting the original amount owed adjusted for any discounts or premiums. The difference between the repurchase price and the carrying value results in either a gain or a loss on retirement, which is recorded on the income statement. If the repurchase price is less than the carrying value, the company realizes a gain; conversely, if it pays more, a loss occurs.

To illustrate, consider RX Enterprises, which issued $100,000 of 7% bonds in 2012 at a discount (94% of face value), resulting in an initial carrying value of $94,000. By January 1, 2013, the market interest rate had dropped to 6%, prompting RX to repurchase the bonds for $106,000. To determine the carrying value at the time of repurchase, we account for the amortization of the discount over the bond's life. With two semiannual periods passed, $600 of the discount has been amortized, leaving a carrying value of $94,600 ($100,000 face value minus $5,400 remaining discount).

In this scenario, the repurchase price of $106,000 exceeds the carrying value of $94,600, resulting in a loss of $11,400 ($106,000 - $94,600). This loss is recorded as a debit in the journal entry. To complete the entry, the bonds payable account is debited for the face value of $100,000, the remaining discount is credited for $5,400, and cash is credited for the total repurchase price of $106,000. This ensures that the journal entry balances, reflecting the financial impact of the bond redemption.

On January 1, 2012, Rx Enterprises issued bonds worth $100,000 with a 7% interest rate, maturing in 10 years. These bonds were sold at a discount, specifically at 94% of their face value, resulting in an initial cash inflow of $94,000. The discount on bonds payable was calculated as the difference between the face value and the cash received, which amounted to $6,000. This discount is amortized over the life of the bonds, which includes 20 semiannual interest payment periods (10 years x 2 payments per year). Therefore, the amortization per period is $300 ($6,000 / 20).

By the end of 2012, after one full year, the total amortization would be $600 (2 periods x $300), leaving a remaining discount of $5,400 ($6,000 - $600). Consequently, the carrying value of the bonds on the books would be calculated as follows: the face value of $100,000 minus the remaining discount of $5,400, resulting in a carrying value of $94,600.

In 2013, Rx Enterprises decided to repurchase the bonds when the market price was $88,000. Since the carrying value of the bonds was $94,600, the company realized a gain on the repurchase. This gain is calculated by subtracting the repurchase price from the carrying value: $94,600 - $88,000 = $6,600.

To record this transaction, the following journal entries are made: the bonds payable account is debited for $100,000 to remove the liability from the books. The discount on bonds payable account is credited for $5,400 to eliminate the remaining balance. Cash is credited for the amount paid, which is $88,000. Finally, to balance the entry, a gain on retirement of bonds is credited for $6,600. This gain reflects the difference between the carrying value and the repurchase price, indicating that the company effectively reduced its liabilities at a profit.