Bonds typically refer to debt securities with a maturity of 10-year or longer and notes refer to debt securities with maturity of 2-10 years. However, often the term bonds and notes are used interchangeably because they have similar accounting treatment.
Relationship between bond features and its issue price
When a company issues a bond, it receives cash from investors in exchange for a promise made by the company to return the principal amount (called face value) back to the investors at the maturity date together with periodic interest at a specified coupon rate (also called nominal rate or stated rate). All the material features of a bond are contained in a contract called a bond indenture.
The cash that a company receives on a bond is a function of the market interest rate prevailing at the time of the issue. Ignoring the issuance costs, the cash proceeds are equal to the present value of future bond cash flows determined at the market rate of interest. When the market interest rate is equal to the coupon rate, cash proceeds equal the face value. However, this is rarely the case. When the market interest rate is higher than a bond’s coupon rate, its cash proceeds are lower than its face value and the bond is said to be issued at a discount. Similarly, when the market interest rate is lower than the coupon rate, a bond is issued at a premium (at an amount greater than its face value). The market rate is called the effective interest rate.
Accounting for issuance of bond
At the time of issuance of a bond, a bond payable is recognized on the issuer’s balance sheet at an amount equal to its cash proceeds, i.e. face value less any discount plus any premium. The transaction is recorded by showing an increase in cash (an asset) and an increase in bonds payable (a liability)
On the issuer’s cash flow statement, cash received from the issue of bond is classified under financing activities.
Treatment of bond issuance costs
Under IFRS, bond issuance costs such as legal fees, commission, etc. are generally subtracted from bonds payable. US GAAP initially required recognition of debt issuance costs as an asset (which was required to be amortized over the tenor of the bond), however, it converged with IFRS and now requires debt issuance costs to be deducted from bond liability. However, SEC still allows the capitalization and amortization approach.
Subsequent measurement: amortized cost
Subsequent to initial recognition, an issuer carries long-term debt on its balance sheet at the amortized cost (also called book value or carrying value), which equals the bond’s face value minus any unamortized bond discount plus any unamortized premium. It is because the issuers intend to retain the debt till maturity and hence any changes in market interest rates and the resultant change in bond values does not affect them.
A bond’s amortized cost reflects the market interest rate at the time the bonds were issued. It does not reflect any change in bond value due to changes in the market interest rate. Generally, when the market interest rate increases, the value of fixed-coupon bonds falls and vice versa. Hence, in an increasing interest rate environment, the book value of a company’s liabilities may be overstated. Conversely, in a declining interest-rate environment, the amortized cost would most likely be less than the fair value and the company’s liabilities will be understated. This shows that the amortized cost does not readily reflect the underlying economic phenomenon.
Fair value option
Accounting standards allow companies to report financial liabilities are fair value by designating them under a category called financial liabilities at fair value through profit and loss. When bonds payable are carried at fair value, a decrease in value is represented as income and any increase as a loss in the income statement. Since changes in fair value can occur both due to changes in interest rates and changes in credit risk, companies must separately disclose the portion attributable to credit risk. They must recognize credit risk in other comprehensive income and changes from the interest rate in profit and loss.
Few companies, mostly financial services firms, use the fair value option to better match the measurement basis of their liabilities with assets.