adjusting journal entries
A bond is a liability companies use when a large amount of cash is needed. Rather than go to a bank or other lender, a company will issue bonds and sell them to the public. By selling bonds on the open market, the company has more control over the terms of the liability, such as interest rate and duration. Market forces still play a part. For example, if the interest rate offered by the company is too low, the public may not be interested in buying the bonds. If the market believes that the company may not pay back the bonds, the market will demand a higher interest rate.
Bonds can be traded, similar to publically traded stocks. It is not uncommon for a bond to have multiple owners before it matures because bonds typically have long maturity periods. According to the Securities Industry and Financial Markets Association, the average maturity of a corporate bond issued in December 2013 was 15 years. Typically, bonds are issued in denominations of $1,000, $5,000 or $10,000. The company determines the total amount of cash it needs to raise with the issuance. Bond certificates are printed and sold to an investment firm, also called an underwriter. The underwriter then sells the bonds to the public. Bonds are subject to the same changes in market value that stocks experience. The market value of a bond relates to the interest rate the bond is paying compared to the rate people can get on other similar investments. The market value can also fluctuate based on the market’s perception of the company’s ability to repay the bond.
A bond certificate will contain the face value of the bond. Face value is the amount that will be received at maturity. This is also called par value. It will also have the stated interest rate and the maturity date. The maturity date is the date the bonds will be repaid unless the company has the option and elects to repay them early.
The face value of a bond is not repaid until the maturity date of the bond unless the company that issues the bond chooses to repay the bond sooner. Only interest payments are made during the life of the bond. At maturity, the bond holder or buyer will receive the face value of the bond.
When a company issues bonds, it must record the amount of cash received and the corresponding liability. Recording the liability is the easiest part because the liability is always equal to the face value of the bond. To determine how much cash will be received, we need to know if the bond will sell for par value.
A bond will sell for par value if the stated interest rate is equal to the market rate. If that is the case, the company will receive cash equal to the face value of the bond.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is also 8%. Record a journal entry for the issuance of the bonds.
Since the stated interest rate and the market rate are the same, these bonds will be sold at face value. The journal entry for a par value bond, like this one, is fairly simple. The accounts will be Cash, to record the increase in cash, and the liability will be called Bonds Payable. The amount of the entry is the face value of the bond.
When the market rate is not the same as the stated or contract rate, the bond payable and cash will not be the same. If the market rate is higher than the stated rate, that means people are not willing to pay as much for the bonds. Either there is risk associated with the company or there are better investments elsewhere. In order to entice the public to buy the bonds, the company must offer a discount on the bonds. The company will receive less cash than face value. The difference between the face value of the bond and the cash received is called the bond discount or discount on bonds payable.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 10%; therefore, the bonds will only bring $350,152. Record the journal entry for the issuance of the bonds.
In this case, the market rate is higher than the stated rate which means that the bonds will sell for less than face value.If the public can get 10% elsewhere, why would they pay full price to only receive 8%? They wouldn’t. So while the bond will pay $400,000 at the end of the 10-year term, the bond is only worth $350,152 right now (we will discuss how you calculate that number later in the material).
The difference between the amount of cash received and the liability is called Discount on Bonds Payable. This is a contra-liability, linked to Bonds Payable. Since Discount on Bonds Payable is a contra-liability, the normal balance is a debit. This makes sense because we need something to add to Cash on the debit side to balance out the $400,000 Bond Payable.
When a company offers a bond at a higher interest rate than the market expects, the public is willing to pay more for the bonds. This causes more cash to come in than the amount of the liability. In cases like this, we say that the bond sells for a premium.
Why would a company offer a bond at a premium? This can occur when the company offers a slightly higher interest rate than the market rate or when the company is so stable that it is almost certain that the creditors will be repaid. In today’s record low interest rate environment, the public is willing to spend a bit more money up front to get a better interest rate.
When a bond sells for a premium, the amount of cash generated from the sale is higher than the liability. In order to balance the journal entry, we create an account called Premium on Bonds Payable. This is an additional liability that attaches to Bonds Payable, just like a contra-account would. However, because the normal balance in Premium on Bonds Payable is a credit balance, it is not considered a contra-liability.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1. The market rate at the time of issuance is 6%; therefore, the bonds will bring $459,512. Record the journal entry for the issuance of the bonds.
Because more cash is generated from the sale than the amount of the outstanding liability, the bonds are selling at a premium. The company will receive $459,512 in Cash but the Bond Payable is only $400,000. The amount of the premium is $59,512 (we will discuss how to calculate the premium later in the material). Cash is increasing, the Bond Payable is increasing and the Premium on Bonds Payable is increasing.
Recording Interest Payments
Most bonds pay interest on a recurring basis, typically annually or semiannually. Bonds that do not pay interest, called zero coupon bonds, are heavily discounted because the current value of a bond is based on the combined value of the interest and principal payment to be received. Since there are no interest payments, buyers look for a return on investment when they purchase the bonds. In order to get that return on investment, the bonds are heavily discounted.
Recording the interest payment on a bond is similar to the calculation used in other types of debt, except when there is a discount or premium. When there is a discount or premium, that amount must be divided up amongst all the interest payments; this is called amortization. On the date the bond matures, the amount of the discount or premium must be fully amortized, meaning that the balance in those accounts must be zero. Each time interest payment is made, a portion of the discount or premium must be included in the entry.
Recording Interest for Par (Face) Value Bonds
The cash payment for interest is calculated based on the principal balance of the bond, the face rate of the bond and the amount of time each interest payment covers. Many times you will see this referred to as:
Since the outstanding principal of a bond is not paid until maturity, the interest payment is always the same.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is also 8%. Record a journal entry for the first interest payment on June 30.
Because this bond was issued at par value, the interest calculation is simple. Just use I = PRT. In this case, principal is $400,000. The interest rate is 8%. Time should be expressed as a fraction of months covered by the payment over the number of months in the year. Since these are semiannual interest payments, each payment is for six months’ worth of interest. You can also look at it from the perspective that there are two payments each year, so therefore, we need to cut the annual interest rate in half.
No matter how we look at it, the time portion of the calculation is the same. Now let’s plug the information into the formula and calculate the cash payment.
Now, we must write the journal entry. The company is going to pay the interest on June 30, so we know that cash is one of the accounts. Interest is a cost of the bond, therefore it is an expense. Interest expense is the other account. Cash is decreasing and the expense is increasing.
Adjusting for interest accrued but not paid
When working with par value bonds the calculation and resulting journal entry are fairly simple. There is one catch, though. What if the bond was issued on December 1, rather than December 31?
The matching principle states that we must match revenue and expenses. Because the bond was issued on December 1, there is one month of interest that must be accrued at the end of the year. We must do an adjusting entry to record the one month worth of interest expense. Because the interest will not be paid until June 1, this also creates a payable: Interest Payable.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 1, 2013. The market rate at the time of issuance is also 8%. Record all entries related to the first interest payment on June 1, 2014
This question is a bit more open-ended than the last, because there are actually two different ways we could handle this. Both involve an adjusting entry and the entry for the payment, but one method requires a reversing entry. If the reversing entry is not done, the entry for the June 1 payment is a bit more complicated. We will run through both versions.
The cash payment on June 1 is still $16,000 because we are still discussing a $400,000, 8% semiannual bond.
The only difference is the timing of the interest expense. One month if interest falls into 2013; five months fall into 2014. The first thing we need to do is figure out the monthly interest. Because this is a six-month payment, we can divide $16,000 by six. For simplicity, we will round to the nearest whole dollar. The monthly interest is $2,667.
If the bonds were repaid on December 31, 2013, the company would be required to repay the bonds plus $2,667 in interest. To ensure the financial statements are complete and accurately reflect all activity, the company must record the $2,667 in Interest Expense. The amount will not be paid until June 1, 2014 so we will record the amount as a liability. It is due to the bondholders, which is why it is a liability.
This entry will be done whether you do the reversing entry or not. The purpose of a reversing entry is to undo an adjusting entry. Why would you undo an adjusting entry? In order to make someone’s job easier! Let’s look at this example without the reversing entry.
On June 30, we need to record the payment of $16,000 to the bondholders. Fairly simple, right? We record cash decreasing by $16,000. We also record $16,000 of interest expense — or do we? Wait, the interest expense is not $16,000 because $2,667 of interest expense was recorded on December 31. The interest expense from January 1 to June 1 is $13,333. So what about the other $2,667 needed to balance the entry? That is in Interest Payable. We need to debit the liability to show that it has been paid off.
Using reversing entries with interest payable
Now if you are the bookkeeper, are you going to remember to record the decrease in the payable? Most likely, the bookkeeper will record the entire $16,000 to interest expense which will require someone to do an adjusting entry later on to fix the error. How can we make the bookkeeper’s life easier? Use a reversing entry!
After the December 31 entry has been completed, we can do a second entry dated January 1 to undo the adjustment. Notice that the adjusting entry is done in the new year. To undo the entry, debit the payable and credit the expense.
How does this solve our problem? Well, I’m sure you can see that the reversing entry clears the payable, bring the balance to zero. What will the entry do to our expense? The expense now has a $2,667 credit balance. On June 1, the bookkeeper records the entry to record interest expense and the payment of the interest.
Let’s look at the T-account for Interest Expense.
By completing the reversing entry, we simplify the entry on June 1! Either method is fine as long as we are consistent.
Recording Interest on a Discounted Bond
With a discounted bond, there are three items that need to be handled when we do the entry for interest payments.
- Calculate how much cash will be paid. The amount of cash required is the same for all bonds with the same face rate and denomination. A $400,000, semiannual 8% bond will require the same amount of cash for the interest payment whether it is sold at par, a discount or a premium. Only the interest expense is affected by the discount or premium.
- Calculate the amount of amortized bond discount. Over the life of the bond, we must amortize or phase out the bond discount. The discount is phased out by using a straight-line approach, similar to amortization for intangible assets.
- Compute the interest expense. The interest expense for a discounted bond is equal to the cash needed for payment plus the amount of amortized bond discount.
Interest expense = Cash + reduction in bond discount
Let’s look at an example to help solidify this concept.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is 10%; therefore, the bonds will only bring $350,152. Record the journal entry for the first interest payment on June 30 assuming the company uses straight-line amortization.
A $400,000 bond that brings $350,152 in cash was discounted $49,848.
First, we will figure out the cash payment. This is an 8% bond where the interest is paid twice a year. Interest is calculated off the face value of the bond. Remember PRT!
This discount must be amortized over the life of the bond. Since it is a 10-year bond with semiannual payments, there are 20 interest payments over the life of the bond. We can take $49,848 divided by 20 payments or $2,492.40. This is the amount of amortization each time an interest payment is made.
Finally, we need to calculate the interest expense. Essentially, the interest expense is pulled into the journal entry. We stated earlier that interest expense is the amount of cash plus the amount the bond discount is reduced.
The three accounts are Cash, Discount on Bonds Payable and Interest Expense. Cash is decreasing so we credit the account. The normal balance in Discount on Bonds Payable is a debit (contra liability), so to reduce the account we will credit the account. Interest Expense is an expense account, so we debit the account. Now we have all the information we need to construct the journal entry.
Notice that the Interest Expense is just plugged into the entry. You cannot calculate the interest expense in a conventional way by multiplying by a percentage rate. Even if you were to look at the market rate, that would not help. The interest at the market rate would be $20,000 ($400,000 * 10% * 6/12). This is actually why companies are willing to sell bonds at a discount. The interest at market rate would be higher than the interest expense at a lower face rate plus the amortized discount.
Recording Interest on a Premium Bond
When a company sells a bond at a premium, the purchasers pay more than face value for the bonds. The premium helps to offset some of the cost of the bonds, lowering the interest expense of the bonds. The amount of cash required for all 8% bonds is the same.
The method for dealing with a bond premium is exactly the same as a bond discount.
- Calculate the amount of cash required using PRT.
- Calculate the amount of bond premium to amortize.
- Compute the interest expense. In this case, the bond premium will reduce the interest expense.
Why does the premium reduce interest expense? The amount of cash is based on the face rate of the bond. Because the bond purchasers paid extra for the bond, the company more money than the face value of the bond. That additional cash helps to offset the amount the company pays in effective interest. A portion of each cash payment is a return of the premium to the purchasers. This lowers the interest expense to the company.
Let’s run through some numbers.
Hill and Valley, Inc. issues $400,000 worth of 10-year, semiannual, 8% bonds on December 31. The market rate at the time of issuance is 6%; therefore, the bonds will bring $459,512. Record the journal entry for the first interest payment on June 30 assuming the company uses straight-line amortization.
If bonds with a face value of $400,000 bring $459,512 in cash, there is a premium on the bonds. The premium is $59,512.
Step 1 is to calculate the amount of cash required. We have a $400,000, 8% semiannual bond.
For each interest payment, Cash will decrease or be credited $16,000.
Step 2 is to calculate the amount of bond premium to be amortized. Since the company uses straight-line amortization, we will record the same amount of amortization each time interest is paid. On a 10-year semiannual bond, there will be 20 payments.
$59,512 / 20 = $2,975.60
Each time an interest payment is recorded, we will amortize $2,975.60 of premium. The normal balance in Premium on Bonds Payable is a credit. Therefore, in order to amortize or reduce the amount of the account, we must debit the account.
The last step is to compute the amount of interest expense. Interest expense is $16,000 less the amount of the amortized premium. When bond purchasers pay a premium it is as though they are offsetting some of the interest. For each payment made, $2,975.60 of the premium is returned to the purchasers which lowers the amount of interest expense for the company. The amount of interest expense is $13,024.40.
We have all the information we need to write the entry.
When working with bonds, remember that a par value bond sells for face value. If the market interest rate is higher than the face rate, the bond will sell for less than face value. The bond will be discounted. If the market interest rate is lower than the face rate, the bond will sell for more than face value. The bond will be sold for a premium.
Discounts and premiums do not affect the amount of cash paid for interest. These items do affect the amount of interest expense recorded by the company. Discounts and premiums must be amortized over the life of the bond, each time an interest payment is made. By the time the bond matures, the discount or premium should have a zero balance. A discount increases the amount of interest expense recorded by the company. A premium reduces interest expense.
Introduction to Bonds
Journal Entries for Bond Issuance
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.