A bond is a debt instrument issued by entities to obtain a loan. It comes with a fixed income, usually based on a fixed interest rate. Usually, companies use bonds to raise debt finance. However, other entities, such as government organizations may also issue bonds to gather funds. Overall, a bond is one of the most commonly used and widely available methods for entities to raise debt finance that doesn’t require them to refer to loans providing financial institutions.
There are many different types of bonds classified based on the issuer, the maturity, interest rate, and risks associated with the bond. The bonds that come with the lowest risk are government-issued bonds known as treasury bills. However, these bonds are usually short-term. Similarly, bonds issued by cities or local governments are known as Municipal bonds. They are riskier as compared to treasury bills. Likewise, corporate bonds are bonds issued by companies or corporations. These come with the highest risk as compared to the others.
The risk associated with a bond also dictates the returns on it. Riskier bonds come with higher returns to compensate for the bondholder. It means government-issued bonds come with the lowest interest rates but greater safety. On the other hand, bonds issued by companies come with the highest interest rates due to the higher risks.
Accounting for a bond
There are several transactions, related to a bond, that occur starting from its date of issue to its maturity. First of all, when an entity issues a bond, it will record a liability in its accounts. The value of the bond depends on its face amount, which is the amount the entity pays back for it on maturity. Therefore, the accounting treatment at the issuance date will be as follows.
Dr Cash
Cr Bonds payable
Sometimes, the company may also sell the bond at a lower price than its face value. In that case, the entity still has to pay back the full amount of face value on maturity. However, it receives lower cash as compared to the bond’s face value. Therefore, the company must record the difference as a discount, which is an expense. The accounting treatment is as follows.
Dr Cash
Dr Discount on bonds payable
Cr Bonds payable
If the entity receives more cash than the face value, it records the difference as other income. It is also known as a premium on bond. The accounting treatment will be as follows.
Dr Cash
Cr Premium on bonds payable
Cr Bonds payable
When the entity pays interest on a bond, it will record the interest as an expense. The accounting treatment for interest on a bond will be as follows.
Dr Interest Expense
Cr Cash/Interest payable
Finally, once the entity repays the bond, it will reverse the liability related to the bond. As mentioned above, the entity repays the lender the face value of the bond. Therefore, the accounting treatment will be as below.
Dr Bonds payable
Cr Cash
Valuing a bond
A fixed-rate bond is valued using the discounted cash flow method. The valuation of a bond with embedded derivatives is more complex. It requires a short-rate model such as the Hull-White method. The valuation steps are as follows,
- Calibrate the short-rate model using market data
- Build an interest-rate tree
- Price the bond
Conclusion
A bond is a debt instrument that entities issue to raise finance. There are different types of bonds categorized based on issuer, risks, interest rates, etc. The accounting for a bond consists of recording it when issued initially. Furthermore, it also consists of recording interest payments associated with bonds. Finally, it also involves writing off the bond when the entity repays the face value of the bond.
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