When a company uses the accrual basis of accounting, it records expenses in the period they were incurred, even if expense was not paid in that period. Although bonds issued in exchange for cash may require the payment of interest on a quarterly, semi-annual or annual basis, the expense is accrued on the company's income statement each month.
The adjusting entries to record the accrual and payment of interest on a bonds payable requires three accounts, interest expense, interest payable -- a liability account, and cash. Interest on the bond is calculated by multiplying the face value of the bond by its interest for the period, expressed with this formula:
Interest = Principal × Rate × Time.
Issuance of the Bond
To illustrate how adjusting entries are made to accrue interest on bonds, assume that on Feb. 1, a manufacturing corporation issues a $40,000, 9 percent, 3-year bond at face value. The bonds are dated Feb. 1, and interest is paid annually on Dec. 31.
On the issue date of Feb. 1, the company records the following entry:
Debit Cash 40,000 Credit Bonds Payable 40,000
Accrual of Interest
The company will accrue the interest it incurs each month from February to December by making the following adjusting entry:
Debit Bond Interest Expense 300 Credit Bond Interest Payable 300
Interest is calculated as the result of $40,000 x 9 percent x 1/12. Since the interest will be paid at the end of the year, the liability account "interest payable", is increased each month to represent the obligation of the payment.
Payment of Interest
At year-end, the company will have accrued eleven months of interest expense at $300 per month, for a total of $3,300. To record the payment, the cash account will be reduced by a credit and the liability account with a debit, resulting in the following adjusting entry:
Debit Bond Interest Payable 3,300 Credit Cash 3,300
The following year, interest expense will be accrued each month as calculated in section three, resulting in a total of $3,600 of interest expense accrued for the year. The cash payment will again debit interest payable for $3,600, and credit cash in the same amount.
In the final year, the company will pay the bond with the following entry:
Debit Bond Interest Expense 300 Debit Bonds Payable 40,000 Credit Cash 40,300
The reduction to the cash account includes the payment of the bond's face value, plus the last month of interest expense on the debt.
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