Redeeming Bonds before Maturity - Video Tutorials & Practice Problems
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Redeeming Bonds Before Maturity
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sometimes a company might repurchase their bonds before they've totally matured. So they'll have these bonds payable, these liabilities that they, oh well they'll just buy them back before they actually mature. Let's check out what happens when that in those cases. Okay. So what this is called, it's called redeeming their bonds when they repurchased them. Okay. 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, hey, I don't want to pay this interest anymore, we've, we've generated enough cash flow through our business. Let's buy back our 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 offer their bonds at 6%. So they could buy back their old bonds where they were paying 10% interest and reissued new bonds at 6% and be paying less interest as that goes forward. Okay. So they could be lowering the, 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 gonna happen is that the company is gonna 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 had to find out whether there was a gain or a loss. Well, the bonds are gonna be repurchased at a different price than the current carrying value of the bonds. Okay. The carrying value is what's gonna be the book value of the bonds right? Where we had some amount in the bar 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 purchase 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 gonna pay a certain amount to repurchase them, right? We're repurchasing a liability and we're gonna get rid of that liability. So if we repurchased it for less than the carrying value, right? If we 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 then we actually would have had to pay in the future that's a gain, the opposite would be a loss. Right? If we paid more than the carrying value. Okay let's go ahead and see how this works. In an example. On january 1st 2002 Rx Enterprises issued 100,000 sorry in 2012 R. X. Enterprises issued 100,000 of 7% bonds maturing in 10 years while other bonds were paying 8%. The bonds issued were issued at 94 paid semi annual interest on january 1st and july 1st during 2012 the market rate of interest dropped to 6% on january 1st 2013 Rx decided to repurchase the bonds when the market price was 106,000. Okay so what's gonna 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 at 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 -94000 Of 6000 was the discount. Now they didn't talk about straight line or effective method. We're always gonna just use the straight line method unless we're told otherwise. Okay, so that discount of 6000 is going to be advertised over the course of the 10 years that the bond exists. Right? Yeah the 10 years and the 10 years uh that we have the bond and we're paying semiannual interest. So we would have had the 6000 in the bond divided by 20 periods right? Since its semiannual, it's 10 years, times two semiannual periods. So 6000 divided by 20 would be 300 per period, right? That we would be advertising it and it's been two periods. So it's essentially been one year. It is 600 advertised, right? We've advertised 600 of this discount uh in the past two periods. Right because we issued them on january 1st 2012 and we're purchasing them january 1st 2013. So it's been two of those semi annual periods, we would have advertised 600 of that discount. So what would have been the carrying value of the bonds? What would have been the 100,000 that was in the bonds payable account and then we would subtract the discount. Right, the discount was 6000 originally, so let me put a t account over here for the discount, we would have originally had a discount of 6000, right? And then we had two journal entries where we would have credited the discount for 300 and left us with 5400 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 uh journal entries play out. But as we do interest expense journal entries we will be crediting the discount to get rid of it. Right? So the remaining discount would be 5400 at this point. Which gives us a carrying value of 100,000 minus 5400 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 gonna get rid of um that we're gonna have a gain or a loss. Right. In this case we repurchased them for 100 6000. Where on our books they were only worth 94,600. So what does this sound like to you again or a loss? It's a bit tricky. This is actually a loss. Right because we had this liability for 94 4000 and we ended up paying it off for 100 6000. 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 the 106,000 minus the 94,600 carrying value. Right? It's a liability. So we had this obligation that we owed 94,600 but we paid it off for 100 6000. So we paid extra we took this loss. So how much is that gonna be 106,000 -94600. That 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 our credits losses are similar to expenses and have debits. So we would have a loss on 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 gonna need to credit our discount, we still have a discount amount of 5400. Right? So we're gonna have a credit to the discount the remaining discount to get it off of our books For 5400. Right? And that should make sense. That's this remaining value over here. Well we need to get rid of it. Okay. Yeah, With a credit 55,400. Let me do it in a different color. 5400. 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 re purchase them with cash? Right. We paid cash to buy them back. So we're gonna have a credit to cash for the 106,000 that we paid for them. And now our journal entry balance is right. The 106,000 in cash minus the carrying value of 105,400. Right? This this right here represents the carrying value of the bonds. This is the repurchase price and then the loss is the plug, right? If it was again while 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 uh for the loss on retirement in this case. Let's pause and let's try another example below
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Redeeming Bonds Before Maturity
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Alright now let's try this example. On january 1st 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 paid semiannual interest on january 1st and july 1st during 2012 the market race increased to 10% on january 1st 2013 Rx decided to repurchase the bonds when the market price was 88,000. Okay. So they told us the repurchase price again, which they're generally gonna have to tell you what that is, 88,000. So now we need to find the carrying value of the bonds and guess what? It's gonna be the same thing as above. Nothing's changed here. But let's go ahead and do that calculation again. So we bought them, we issued them at 94. So 100,000 times 94%. Well that tells us 94,000 was the original amount we brought in. So we had a discount Of 100,000 -94000 equals 6000. Right? And that's 6000 discount. We're gonna advertise Over the 20 interest payment periods 10 years, two payments per year, 6000 divided by 20 is 300 per period. And it's been two periods, right? Cause it's been one full year. So we've advertised 600 has been advertised. So just like we saw above, we're gonna have that same uh situation where we've advertised from the 6000 original balance in the discount account, we would have advertised 300 another 300 been left with 5400. Right? So 5400 is the left in the in the discount account. So we would do the carrying value would be 100,000 minus 5400 equals the 94,600. Right? So now notice what happened, we've got a carrying value. We have this liability that we owe 94,600 but we're able to repurchase it, we're able to get it off of our books for only 88,000. Right? In this case we have a gain right? We're gonna have a gain because um we bought it back for less than it was on our books and it's a liability. So we have the 94,600 minus 88,000. That tells us that our gain In this case, I don't want to mess up the math. It's been a long day. 6600. Okay 6600 is gonna be our game. Let's go ahead and make our journal entry. Okay, just like before we know we're going to debit bonds payable Right, we have to debit bonds payable to get it off of our books for 100,000 And we know we got to get the discount off of our books. The discount on bonds payable has to get off of our books and that was in the amount of 50 400 right? The amount that was left 5400 over here. That had to go to leave us with a zero balance. So that was the credit to discount on bonds payable to get it off of our books right? We had to credit the 5400 to get it off of our books and leave us with a zero balance. Well what else happened? We know we paid cash right? We had cash and we paid 88,000 in cash but we don't balance right. And guess what's gonna balance us is that gain on retirement of bonds? Just put gain on retirement And that is a credit right gains are credits 6600 we balanced there. Right? So in this case notice our carrying value of the bonds, the 100,000 minus the discount is more then the repurchase price. So we have a gain and the gain is a plug. It's what makes this balance. We needed credits of 6600 to make this balance and we plugged that in there. Cool. So that's about it for the redeeming of bonds before maturity. Let's go ahead and move on to the next