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Chapter 2.93® - Retirement of Bonds at Maturity, Before Maturity and by Converting to Shares - Exercising a Bond Call Option, Book Market Value & Call Back Price

i) Bond Retirement at Maturity

The carrying value of bonds at maturity will always equal their par value and both a discount and a premium on a bond will equal the par value at maturity. Assume Backstreet Oil Corp. offers a $100,000 par value bond with a contract interest rate of 15% with interest payable annually and a 4 year bond life. In the bond example above, here is the journal entry that Backstreet Corp. will record when it repays the bond par value in 4 years.

December 31st, 2013

Account Name

Dr. Bond Payable   $100,000  
Cr. Cash   $100,000
Entry to record issuance of bonds payable at par and 15% contract rate.

iii) Bond Retirement before Maturity

Companies sometimes like to retire some or all of their bonds before maturity. For instance, if interest rates decline significantly, a company may wish to replace high interest paying bonds with low-interest paying bonds. Two most common ways to retire bonds before maturity are:

i) Exercise a call option

ii) Purchase them on the open market

A corporation can reserve the right to retire bonds earlier than their useful life or maturity term by issuing callable bonds. Callable bonds mean the bond indenture gives the issuing company an option to call the bonds before they mature by paying the par value plus a call premium to the bondholders. This is exercising a call option. In the 2nd instance, the company can repurchase the bonds on the open bond trading markets at their current price. When there is a difference between the bonds’s carrying value and the amount paid in the bond purchase price, the issuer records a gain or loss equal to the difference. Also, any unrecorded discount or premium up to the date of the call must be recorded to bring the carrying value of the bond up to date.

To illustrate bond retirement before maturity, let’s assume Backstreet Corp. issues callable bonds with a par value of $100,000 just like the example above. The call option requires the issuer to pay a call premium of $4000 to bondholders plus the par value if it chooses to retire the bonds earlier than their maturity date. After the 2nd quarter of the year on June 30th, 2009, the bonds have a carrying value of $105,500. On the next day, July 1st, 2009, the issuer calls these bonds and pays $104,000 to the bondholders (par value $100,000 + call premium $4,000). Backstreet Corp. would then realize a gain of $1,500 because:

Bond Market Value = $105,500

Call back price = $104,000

Gain on calling back the shares = $1,500

The journal entry to record this transaction is:

July 1st, 2009

Account Name

Dr. Bonds Payable   $100,000  
Dr. Premium on Bonds Payable
Cr. Gain on Retirement bonds   $1,500
  Cr. Cash   $104,000
Entry to record retirement of bonds before maturity by issuing a call premium.

A company is usually required to call all of its bonds when it exercises a call option; however it can choose to retire as many or as few of the bonds as it chooses to through open market transactions.

iii) Bond Retirement by Conversion to Shares

Convertible bonds are different than callable bonds in that they give the bondholders the right to convert their bonds to a specified number of the company’s common shares trading on the stock market. When conversion occurs, the carrying value of bonds is transferred from long-term liability accounts on the Balance sheet to contributed capital account and no gain/loss is recorded.

For instance, consider Backstreet Corp. issues $100,000 par value bonds with a carrying value of $100,000. The bondholders choose to convert these bonds to shares, at 20,000 common shares. The entry to record this conversion is:

January 1st , 2009

Account Name

Dr. Bonds Payable   $100,000  
Cr. Common Shares   $100,000
Entry to record retirement of $100k par value bonds by conversion to common shares (by issuing 20,000 shares in exchange).

Notice in the above entry, the market prices of the bonds and the common shares have no effect on the value of the bonds. However, if there was a premium or a discount on bonds payable, it must be removed. For instance if there was a $5000 discount on bonds payable, then the journal entry will be:

January 1st , 2009

Account Name

Dr. Bonds Payable   $100,000  
Cr. Common Shares   $95,000
Cr. Discount on Bonds Payable   $5,000
Entry to record retirement of bonds by conversion to common shares. Also, to remove a discount on bonds payable.

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