Bonds and Debt

Learning Objectives

• Explain bond pricing as a conservation-law consequence of rate mismatch
• Calculate bond issue prices and record issuance at par, premium, and discount
• Apply the effective interest method to amortize premiums and discounts
• Compute gain or loss on early extinguishment of debt
• Apply the 10% test to distinguish debt modification from extinguishment under ASC 470-50
• Account for convertible debt under ASU 2020-06
• Understand the fair value option for financial liabilities under ASC 825

The Core Idea: A Bond Is Conservation with a Time-Value Correction

When a company issues a bond, the conservation law holds perfectly — cash in equals obligation created. But when the coupon rate the issuer offers differs from the rate the market demands, the issue price adjusts so that the market gets its required return regardless. The premium or discount is not a gain or loss. It is a time-value adjustment that will unwind over the bond's life.

This is the single structural insight that makes everything else in this lesson mechanical:

• At par — the coupon rate equals the market rate. No adjustment needed. Cash received = face value.
• At a premium — the coupon overcompensates investors. They pay more than face value for the right to receive above-market interest. The premium is the present value of the excess coupon payments.
• At a discount — the coupon undercompensates investors. They pay less than face value, and the discount represents additional return they will receive at maturity. The discount is the present value of the coupon shortfall.

In every case, the investor's total return is exactly the market rate. The bond's price is the mechanism that enforces this.

Bond Issuance Mechanics

The issue price is the present value of all future cash flows (coupons + principal) discounted at the market rate:

Issue Price = PV of Annuity (coupons) + PV of Lump Sum (face value)

Worked Example — Discount Bond

A company issues a $500,000 bond, 8% stated rate, 10-year term, interest paid semiannually. The market rate is 10%.

Step 1 — Identify the variables:

• Semiannual coupon = $500,000 x 8% / 2 = $20,000
• Periods = 10 x 2 = 20
• Market rate per period = 10% / 2 = 5%

Step 2 — Calculate present values:

• PV of coupons = $20,000 x PV annuity factor (5%, 20 periods) = $20,000 x 12.4622 = $249,244
• PV of principal = $500,000 x PV single sum factor (5%, 20 periods) = $500,000 x 0.3769 = $188,450

Issue price = $249,244 + $188,450 = $437,694

Discount = $500,000 - $437,694 = $62,306

Journal entry at issuance:

Conservation check: the entity received $437,694 of cash and created a $500,000 face obligation, but the net carrying amount is $437,694 (face minus discount). The balance sheet balances. The discount is deferred interest — additional cost the entity will recognize over the bond's life.

Premium Bond — Entry Pattern

If the same bond were issued when the market rate was 6% (coupon 8% > market 6%), investors would pay above face value:

The premium is not income — it is prepaid interest. Investors overpaid today and will be "repaid" over the bond's life through coupon payments that exceed the economic cost of borrowing.

The Effective Interest Method

U.S. GAAP requires the effective interest method for amortizing premiums and discounts. Three lines, every period:

The full computation each period:

1. Interest Expense = Carrying Amount x Market Rate (per period)
2. Cash Interest Paid = Face Value x Stated Rate (per period)
3. Amortization = |Interest Expense - Cash Paid|

Discount Amortization Schedule (First 3 Periods)

Using the worked example above ($500,000 face, 8% stated, 10% market, semiannual):

Pattern for discounts: Interest expense exceeds cash paid. The difference amortizes the discount. Carrying amount increases toward face value each period. Interest expense grows because the base (carrying amount) grows — this is compounding.

Pattern for premiums: Cash paid exceeds interest expense. The difference amortizes the premium. Carrying amount decreases toward face value each period. Interest expense shrinks because the base shrinks.

Journal entry — discount amortization (Period 1):

The straight-line method is acceptable only if results are not materially different from effective interest. The CPA exam expects the effective interest method.

Debt Issuance Costs

Underwriting fees, legal fees, and registration costs are presented as a direct deduction from the carrying amount of the bond — similar to a discount. They increase the effective interest rate because the entity received less net cash but owes the same face amount.

Example: $500,000 bond issued at par with $15,000 of issuance costs.

The issuance costs amortize over the bond's life using the effective interest method, adding to interest expense each period.

On the balance sheet, debt issuance costs are a direct deduction from the bond liability — not reported as a separate asset. Carrying amount = Face ± premium/discount - unamortized issuance costs.

Bond Retirement and Early Extinguishment

When bonds are retired before maturity, compare the reacquisition price to the carrying amount:

• Reacquisition price > Carrying amount → Loss on extinguishment
• Reacquisition price < Carrying amount → Gain on extinguishment

Gains and losses on extinguishment are reported in income from continuing operations.

Worked Example — Early Retirement

A $1,000,000 face bond has an unamortized discount of $40,000 and unamortized issuance costs of $10,000. The entity calls the bond at 103 (103% of face).

Carrying amount = $1,000,000 - $40,000 - $10,000 = $950,000

Reacquisition price = $1,000,000 x 103% = $1,030,000

Loss = $950,000 - $1,030,000 = ($80,000)

Conservation check: the $1,000,000 liability and $40,000 discount (net $960,000 obligation including issuance costs) are removed. Cash of $1,030,000 exits. The $80,000 difference reduces equity through the loss — the equation closes.

Debt Modification vs. Extinguishment — ASC 470-50

When existing debt terms are changed, the accounting depends on whether the modification is substantial enough to be treated as an extinguishment of old debt and creation of new debt:

The 10% Test

If the same creditor remains, compare the present value of cash flows under the new terms to the present value under the old terms. If they differ by more than 10%, the change is substantial enough to constitute an extinguishment.

Extinguishment treatment:

• Derecognize the old debt
• Record the new debt at fair value
• Recognize gain or loss on the difference
• Capitalize new fees (they are costs of the new debt)

Modification treatment:

• Keep the old debt on the books
• Adjust the effective interest rate prospectively to equate the carrying amount with the new cash flows
• Expense third-party fees immediately
• Adjust carrying amount for creditor fees

Creditor Change

If the creditor changes (new lender replaces the original), it is always an extinguishment — regardless of the 10% test. The original obligation has been settled; a new one exists with a different party.

Troubled Debt Restructuring — ASC 470-60

A troubled debt restructuring (TDR) occurs when a creditor grants a concession it would not normally consider, due to the debtor's financial difficulty. Two forms exist from the debtor's perspective:

Transfer of Assets or Equity

The debtor transfers assets or equity interests to settle the debt. Two separate gains/losses may arise:

1. Gain on restructuring = Carrying amount of debt - Fair value of assets/equity transferred
2. Gain/loss on asset disposition = Fair value of assets - Carrying amount of assets

Modification of Terms

The creditor reduces the interest rate, extends maturity, reduces face, or forgives accrued interest.

If total future cash payments < Carrying amount of debt:

• Reduce the liability to total future cash payments
• Recognize a gain for the difference
• No interest expense recognized going forward (all future payments reduce the liability)

If total future cash payments ≥ Carrying amount of debt:

• No gain recognized
• Compute a new effective interest rate that equates the carrying amount with the new cash flows
• Apply prospectively

ASU 2022-02 eliminated TDR-specific guidance for creditors and replaced it with the general loan modification framework. However, debtor-side TDR guidance under ASC 470 remains in effect and is tested on the CPA exam.

Convertible Debt — ASU 2020-06

Convertible bonds give holders the right to convert the bond into a specified number of common shares. ASU 2020-06 simplified the accounting significantly by eliminating the prior beneficial conversion feature and cash conversion models.

Key Rules (Post-ASU 2020-06)

• At issuance — record the full proceeds as a single liability. No bifurcation into debt and equity components. No APIC entry for the conversion feature.
• Amortization — amortize any discount using the effective interest method over the bond's life
• On conversion — reclassify the carrying amount of the debt to equity. No gain or loss is recognized.
• Induced conversion — if the issuer offers additional consideration (a "sweetener") to encourage conversion, the fair value of the additional consideration is recognized as conversion expense

Diluted EPS — If-Converted Method

Convertible debt affects diluted EPS using the if-converted method:

1. Numerator adjustment: Add back after-tax interest expense on the convertible debt (because if converted, there would be no interest)
2. Denominator adjustment: Add the shares that would be issued upon conversion
3. Include only if dilutive — if the result increases EPS, exclude (anti-dilutive)

In-Substance Defeasance — ASC 405-20

An entity cannot derecognize debt simply by placing assets in a trust to service it. Under ASC 405-20, debt is extinguished only when:

1. The debtor pays the creditor and is relieved of the obligation, OR
2. The debtor is legally released from being the primary obligor

Placing assets in an irrevocable trust (in-substance defeasance) does not qualify as extinguishment unless the debtor is legally released. The liability and the trust assets remain on the balance sheet.

Fair Value Option — ASC 825

ASC 825 permits entities to elect the fair value option for certain financial liabilities, including bonds payable:

• Elected instrument-by-instrument at initial recognition
• The election is irrevocable
• The liability is measured at fair value each reporting period
• Changes in fair value flow through earnings (not OCI)
• Eliminates the need for discount/premium amortization — carrying amount simply equals fair value

The fair value option is useful when an entity has economic hedges that don't qualify for hedge accounting. Measuring the liability at fair value reduces the accounting mismatch between the hedge instrument (at fair value through earnings) and the hedged item.

A counterintuitive result: when an entity's credit risk deteriorates, the fair value of its debt decreases (investors would pay less for it), which creates a gain in earnings. The entity's own financial distress improves its reported income. This is economically correct (the obligation is worth less) but often confuses readers.

Debt with Covenants — Classification Impact

If a debtor violates a debt covenant, long-term debt is reclassified as current unless:

1. The creditor waives the violation for a period of more than one year after the balance sheet date, OR
2. It is probable the debtor can cure the violation within the specified grace period (and the grace period extends at least one year)

This mirrors the current/noncurrent classification rules from the payables lesson — the existence of the lender's right to demand payment, not its exercise, determines classification.