How to Record the Retirement of Bonds

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  • 0:01 What Are Bonds?
  • 0:54 Selling Bonds
  • 1:59 Retire Bonds at Maturity
  • 2:17 Early Retirement at a Loss
  • 3:38 Early Retirement at a Gain
  • 3:54 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define bonds and discuss their components and the callable feature. You'll also learn how to record a retired bond at maturity and see the difference in recording a gain or loss.

What Are Bonds?

Jan is an investment banker at one of the top firms in the country. Her largest client called and asked if she could provide a seminar to newly hired accountants on the retirement of bonds. Jan told her client she would be more than happy to facilitate the seminar.

The following week she starts her presentation by asking, 'Does everyone remember how to define a bond?' A few people raised their hand. So, Jan said, 'A bond is an investment instrument whereby an investor loans a company money in return for periodic interest payments.

As accountants, your main function, as it relates to bonds, is to record the retirement of bonds. There are three different ways to report the retirement of bonds: at maturity, early retirement at a loss and early retirement with a gain. For the rest of this lesson, we'll discuss the components of a bond and explore how to report the retirement of bonds based on maturity, a gain or loss.

Selling Bonds

When a company wants to expand and grow, they have three options to finance the expansion: sell stock, receive a loan from a financial institution or sell bonds. Bonds are similar to an IOU. A bond is a contractual arrangement between a company and investor whereby the investor loans the company money. The loan is considered the principal. The agreed upon date the bond will be paid back is called the maturity date.

Even though the investor will receive the principal back once the bond matures, the company must incur a cost of borrowing the money; the company must pay interest to the investor. Investors expect annual interest payments, called coupon payments, until the bond matures.

Let's look at an example. Company XYZ issues bonds for $1,000 with annual coupon interest payments of $150 and a maturity date of five years. The bonds will be listed as a long-term liability on the balance sheet. A liability is an obligation the company owes. Most bonds are listed as long-term liabilities since they will be paid back sometime in the future, usually longer than a year.

Retire Bonds at Maturity

Once the bond reaches maturity, after the five years in our example, the bond is retired, and the investors are repaid in full and the liability is removed from the balance sheet. Now let's see what happens if the bond is retired before the 5-year maturity date.

Early Retirement at a Loss

Since bonds are held for quite some time, they have various features to help minimize losses for the issuer. One of those features is called a callable. A callable bond allows the issuer to retire the bond early. Companies sometimes pay off the bond early due to market conditions, investment opportunities or interest rates. Interest rates are the most common reason why bonds are called in or retired early.

Let's look at Company XYZ's bond issuance. They issued $1,000 bonds with $150 annual coupon interest payments or a coupon interest rate of 15% ($150 / $1,000). If a similar bond goes on the market for 7.5% coupon interest rate or a $75 annual coupon interest payment, the company may call the bond in and retire it. Then reissue a new bond at the lower rate of 7.5% coupon interest instead of 15%.

When a company retires the bond early, they may pay more than the bond is worth. For example, in year three, the company decides to call in the bond for $1,200. The journal entry will look like this:

Item debit credit
Bonds payable $1,000
Extraordinary loss $200
Cash $1,200

The $1,000 debit to bonds payable reduces the bonds payable liability. The $1,200 credit to cash represents payment to the bondholder. The extraordinary loss is the difference.

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