Redeeming Bonds before Maturity: Study with Video Lessons, Practice Problems & Examples

Companies may redeem bonds before maturity to stop interest payments or take advantage of lower interest rates. When repurchasing bonds, the difference between the repurchase price and the carrying value results in a gain or loss on retirement. For example, if bonds with a carrying value of $94,600 are repurchased for $106,000, a loss of $11,400 occurs. Conversely, if repurchased for $88,000, a gain of $6,600 is realized. Proper journal entries must reflect these transactions, ensuring accurate accounting of liabilities and gains or losses.

Redeeming Bonds Before Maturity

Sometimes a company might repurchase their bonds before they totally mature, so they'll have these bonds payable, these liabilities that they owe, well, they'll just buy them back before they actually mature. Let's check out what happens in those cases, okay? What this is called, it's called redeeming their bonds when they repurchase them. And this is if you repurchase them before maturity, what we're saying we're redeeming them early. Why would a company want to do this? Why would they want to redeem the bonds early? Well, maybe they no longer require the loan and desire to stop paying interest. Right? If they just say, I don't want to pay this interest anymore, we've generated enough cash flow through our business, let's buy back our loan and stop paying interest. But the more common reason they might do this is that interest rates have fallen, right? Imagine when they first issued the bonds, they were repurchasing old bonds that were paying 10% interest and now interest rates have fallen to 6%, so they could offer their bonds at 6%. So they could buy back their old bonds where they were paying 10% interest and reissue new bonds at 6% and be paying less interest as that goes forward, okay? So they could be lowering the interest that they're paying effectively there, right? Okay? So that would be the main reasons why they might redeem their bonds early. But what's going to happen is that the company is going to repurchase their bonds just like we saw when we were buying and selling or when we were selling equipment, there was some carrying value of the equipment and then some different price that we sold the equipment for, right? And we have to find out whether there was a gain or a loss. Well, the bonds are going to be repurchased at a different price than the current carrying value of the bonds. Okay? The carrying value is what's going to be the book value of the bonds, right, where we had some amount in the bonds payable account and then some amount in a discount or premium account. That's going to be the carrying value of the bonds, so we need to retire based on those carrying values and the price we paid, okay? So the difference between the repurchase price and the carrying value will result in a gain or a loss. Okay? And that will be a gain or loss on retirement that goes to the income statement. Okay? That will be on the income statement. So how do we calculate that? Well, we're going to pay a certain amount to repurchase them, right? We're repurchasing a liability and we're going to get rid of that liability. So if we repurchased it for less than the carrying value, right? If we got a good deal, let's say the bonds were sitting there for $20,000 that we owed, but we only repurchased them for $15,000, well we got a good deal. We had a gain on that retirement, right? We paid less than we actually would've had to pay in the future, that's a gain. The opposite would be a loss, right? If we pay more than the carrying value, okay? Let's go ahead and see how this works in an example. On January 1, 2012, RX Enterprises issued $100,000 of 7% bonds maturing in 10 years while other bonds were paying 8%. The bonds issued were issued at 94 and paid semiannual interest on January 1 and July 1. During 2012, the market rate of interest dropped to 6%. On January 1, 2013, RX decided to repurchase the bonds when the market price was $106,000. Okay? So what's going to happen here? We need to find the carrying value of the bonds and the repurchase price. They told us the repurchase price was $106,000. Now, we need to find the carrying value of the bonds. So when they were issued, they were issued at 94, so they were issued for $100,000 times 94%, which is $94,000, right? They were issued for $94,000. So what did that mean? That there was a discount equal to $100,000 minus $94,000 of $6,000 was the discount. Now they didn't talk about straight line or effective method. We're always going to just use the straight line method unless we're told otherwise, okay? So that discount of $6,000 is going to be amortized over the course of the 10 years that the bond exists, right? Or yeah, the 10 years and the 10 years that we have the bond and we're paying semiannual interest, so we would have had the $6,000 in the bond divided by 20 periods, right? Since it's semiannual, it's 10 years times 2 semiannual periods. So $6,000 divided by 20 will be $300 per period, right, that we would be amortizing it and it's been 2 periods. So it's essentially been 1 year. It's just $600 amortized, right? We've amortized $600 of this discount, in the past two periods, right? Because we issued them on January 1, 2012 and we're repurchasing them January 1, 2013. So it's been 2 of those semiannual periods, we would have amortized $600 of that discount. So what would have been the carrying value of the bonds? Well, it would have been the $100,000 that was in the bonds payable account and then we would subtract the discount, right? The discount was $6,000 originally so let me put a T account over here for the discount. We would have originally had a discount of $6,000, right? And then we had 2 journal entries where we would have credited the discount for $300 and left us with $5,400 in the discount as a debit balance, right? So if this is tricky to you, you might want to go back to where we first study discounts and see how these journal entries play out. But as we do interest expense journal entries, we would be crediting the discount to get rid of it, right? So the remaining discount would be $5,400 at this point which gives us a carrying value of $100,000 minus $5,400, which is $94,600, is our carrying value. $94,600 and the repurchase price was $106,000, okay? So what does that tell us? Well, it tells us that we're going to get rid of, or that we're going to have a gain or a loss, right? In this case, we repurchased them for $106,000 where on our books, they were only worth $94,600. So what does this sound like to you? A gain or a loss? It's a bit tricky. This is actually a loss, right? Because we had this liability for $94,600 and we ended up paying it off for $106,000. We paid more for it than was the original $94,600 that was on our books. So the loss is going to be equal to $106,000 minus the $94,600 carrying value, right? It's a liability. We so we had this obligation that we owed $94,600, but we paid it off for $106,000, so we paid extra. We took a loss. So how much is that going to be? $106,000 minus $94,600 comes out to $11,400 of a loss. Okay? So that's going to be a loss and we know that losses have a debit balance, right? Gains are like revenues and are credits. Losses are similar to expenses and have debits. So we would have a loss on the retirement of bonds would be a debit for $11,400, but we need to get rid of everything else related to these bonds from our journal entry, right? So we had this credit balance for bonds payable, right? The $100,000 credit balance for the face value, we always put the face value in the bonds payable account. Well, we need to get rid of that. We're going to debit bonds payable to get rid of that $100,000 value. But we're still not balanced, right? We're going to need to credit our discount. We still have a discount amount of $5,400, right? So we're going to have a credit to the discount, the remaining discount, to get it off of our books for $5,400, right? And that should make sense, that's this remaining value over here. Well, we need to get rid of it with a credit of $5,400. Let me do it in color, $5,400, and now there's no more balance on our books once we put this credit from our journal entry. So what else is left to balance this? Well, how did we repurchase them? With cash, right? We paid cash to buy them back, so we're going to have a credit to cash for the $106,000 that we paid for them. And now our journal entry balances. Right? The $106,000 in cash minus the carrying value of $100,000, $5,400, right? This right here represents the carrying value of the bond. This is the repurchase price and then the loss is the plug, right? If it was a gain, well, the carrying value would have been more than the repurchase price, and we would have had a gain to balance this out. Okay? So that is our journal entry for the loss on retirement in this case. Let's pause and let's try another example below.

Redeeming Bonds Before Maturity

On January 1, 2012, RX Enterprises issued $100,000 of 7% bonds maturing in 10 years while other bonds were paying 8%. The bonds were issued at 94 and paid semi-annual interest on January 1 and July 1. During 2012, the market rate increased to 10%. On January 1, 2013, RX decided to repurchase the bonds when the market price was $88,000.

Given the facts, the repurchase price is $88,000. The initial issue price was 94% of the $100,000, equating to $94,000; thus, creating a discount of $100,000 - $94,000 = $6,000. This $6,000 discount will be amortized over 20 interest payment periods (10 years, 2 payments per year), resulting in $300 per period. After 2 periods (1 full year), $600 of the discount has been amortized, so the remaining discount balance is $5,400. Therefore, the carrying value of the bonds is $100,000 - $5,400 = $94,600.

When RX repurchases the bonds for $88,000, they realize a gain, because their liability on the books ($94,600) is higher than the repurchase amount ($88,000), leading to a gain of $94,600 - $88,000 = $6,600. The journal entry would include a debit to Bonds Payable of $100,000, a credit to the Discount on Bonds Payable of $5,400, a cash payout or debit of $88,000, and a gain on the retirement of bonds credited for $6,600 to balance the transaction.

This completed transaction shows how RX Enterprises capitalized on the opportunity to retire their bonds at a price lower than their carrying value, resulting in a financial gain.

Here’s what students ask on this topic:

Why do companies redeem bonds before maturity?

Companies may redeem bonds before maturity for several reasons. One primary reason is to stop paying interest if they no longer need the loan. For example, if a company has generated enough cash flow, it might choose to repurchase the bonds to save on interest payments. Another common reason is to take advantage of lower interest rates. If interest rates have fallen since the bonds were issued, the company can repurchase the old bonds and issue new ones at a lower rate, thereby reducing their interest expenses.

How do you calculate the gain or loss when redeeming bonds before maturity?

To calculate the gain or loss when redeeming bonds before maturity, you need to compare the repurchase price with the carrying value of the bonds. The carrying value is the face value of the bonds minus any unamortized discount or plus any unamortized premium. If the repurchase price is less than the carrying value, the company realizes a gain. Conversely, if the repurchase price is more than the carrying value, the company incurs a loss. The formula is:

$\mathrm{Gain}/\mathrm{Loss}=\mathrm{Carrying} \mathrm{Value}-\mathrm{Repurchase} \mathrm{Price}$

What journal entries are made when bonds are redeemed before maturity?

When bonds are redeemed before maturity, several journal entries are required. First, debit the Bonds Payable account for the face value of the bonds. Next, credit the Discount on Bonds Payable account for any remaining unamortized discount. Then, credit the Cash account for the repurchase price. Finally, if there is a gain, credit the Gain on Retirement of Bonds account; if there is a loss, debit the Loss on Retirement of Bonds account. These entries ensure that the company's financial statements accurately reflect the transaction.

What is the carrying value of a bond, and how is it calculated?

The carrying value of a bond is the net amount at which the bond is reported on the balance sheet. It is calculated as the face value of the bond minus any unamortized discount or plus any unamortized premium. For example, if a bond with a face value of $100,000 is issued at a discount of $6,000, and $600 of the discount has been amortized, the carrying value would be:

$\mathrm{Carrying} \mathrm{Value}=\mathrm{Face} \mathrm{Value}-\mathrm{Unamortized} \mathrm{Discount}$

In this case, $100,000 - $5,400 = $94,600.

What happens if a company repurchases bonds at a price higher than their carrying value?

If a company repurchases bonds at a price higher than their carrying value, it incurs a loss. This is because the company is paying more to settle the liability than the amount recorded on its books. For example, if the carrying value of the bonds is $94,600 and the repurchase price is $106,000, the loss would be:

$\mathrm{Loss}=\mathrm{Repurchase} \mathrm{Price}-\mathrm{Carrying} \mathrm{Value}$

In this case, $106,000 - $94,600 = $11,400.