14.5: Issuing and Accounting for Serial Bonds

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Define a “serial bond.”
2. Identify the steps to calculate the price of a bond and provide the proper accounting.
3. Record a serial bond over its life.
4. Explain the periodic determination of interest for a serial bond and the amount that must be compounded each period.

Question: The previous section of this chapter looked at term bonds. Interest was paid each period although payment of the face value did not occur until the end of the four-year term. How does this process differ for a serial bond where both interest and a portion of the face value are paid periodically?

To illustrate, assume that Smith Corporation issues a four-year, $1 million serial bond on January 1, Year One, paying a 5 percent stated interest rate at the end of each year on the unpaid face value for the period. The bond contract specifies that$250,000 of the face value is also to be paid annually at the same time as the interest. Smith and the potential investors negotiate for some time and finally agree on a 6 percent annual effective rate. What accounting is appropriate for a serial bond?

Answer: In reporting a term bond, five steps were taken:

1. The cash flows required by the bond contract are listed.
2. The total present value of these cash flows is computed using the effective rate of interest negotiated by the parties. Present value mathematically removes all future interest at the appropriate rate. Only the principal remains. Thus, this resulting figure is the exact amount to be paid so that the agreed-upon interest rate is earned over the life of the bond.
3. The bond is recorded at the principal (present value) amount paid by the investors.
4. The debtor pays interest periodically on the dates indicated in the contract.
5. The effective rate method is applied. Interest to be reported for each period is determined by multiplying the principal balance of the bond by the effective interest rate. The cash interest figure is adjusted to this calculated amount with the difference compounded (added to the principal)1.

This same process is applied when a serial bond is issued. The sole difference is that additional payments are made periodically to reduce the face value of the debt.

For the Smith Corporation serial bond described above, the following steps are required.

Identify cash flows specified in the bond contract. As a serial bond, Smith is required to pay $250,000 to reduce the face value each year. In addition, the unpaid face value for Year One is$1 million so the 5 percent stated rate necessitates a $50,000 year-end interest payment. Following the first principal payment, the remaining face value is only$750,000 throughout the second year. Thus, the interest payment at the end of that period falls to $37,500 ($750,000 × 5 percent). Based on the contract, the cash flows required by this bond are as follows.

Figure 14.16 Cash Payments Required by Bond Contract

 Year Beginning Face Value Cash Interest Rate Cash Interest Principal Payment Ending Face Value One $1,000,000 5%$50,000 $250,000$750,000 Two 750,000 5% 37,500 250,000 500,000 Three 500,000 5% 25,000 250,000 250,000 Four 250,000 5% 12,500 250,000 -0-

Determine present value of the cash flows. These required cash flows can be organized in either of two ways.

1. First, they can be viewed as an ordinary annuity of $250,000 per year for four years plus four separate single amounts of$50,000 (one year), $37,500 (two years),$25,000 (three years) and $12,500 (four years). 2. Second, the payments of the face value and interest can be combined for each year so that there are four separate single amounts of$300,000 (one year), $287,500 (two years),$275,000 (three years), and $262,500 (four years). The same cash flows are being described so the present value of both patterns will be the same$977,714 whichever approach is followed.

Present Value of an Ordinary Annuity of $1 http://www.principlesofaccounting.co...aryannuity.htm Figure 14.17 Computation of Present Value of Serial Bond—First Pattern of Cash Flows Figure 14.18 Computation of Present Value of Serial Bond—Second Pattern of Cash Flows Record the principal amount received for the bond. Based on this computation, if$977,714 is paid for this four-year $1 million serial bond with an annual stated rate of 5 percent, the effective rate being earned by these cash flows will be 6 percent per year. Accepting a discount of this amount increases the effective rate of interest from 5 percent to exactly 6 percent. The issuance of the bond is recorded through the following journal entry. Figure 14.19 January 1, Year One—Issuance of$1 Million Serial Bonds Paying 5 Percent Annual Interest with Effective Negotiated Rate of 6 Percent Payment of stated cash interest at 5 percent annual rate. Because of the terms specified in the contract, interest of $50,000 will be paid at the end of Year One,$37,500 at the end of Year Two, and so on as the face value is also paid. The Year One payment is recorded as follows.

Figure 14.20 December 31, Year One—Payment of 5 Percent Interest on Serial Bond 