Companies have a number of ways they can obtain cash on hand in order to manage their day-to-day business and invest in future growth. These methods include anything from a small business bank loan to an owner’s personal investment to a corporation issuing stocks and bonds for purchase. Each of these money-raising methods must be accounted for in its own way in a company’s financial reports.
What Are Bonds?
Bonds are a type of loan made to a large organization such as a company, a city or even the government. Depending on the type of bond, the organization may be required to pay interest to the loaning party on this loan, and it is expected to return the principal at the end of a certain time period, terminating the loan. Bonds are therefore considered a low-risk investment, as the principal is returned to the bond holder once the bond matures. Due to this, however, bonds are likely to have a lower rate of return than the (much riskier) stock market.
Bonds have an initial sale value (face value) and a coupon rate — the interest rate and the schedule on which interest payments will be made. They also will have a termination date, likely in a couple of years. Because bonds can be resold on a market and often are, their true value can change over time.
There is a complicated relationship between the government and banking industry interest rates along with the interest rate on the bond and the way that bond is being resold. Also remember that the value of money changes over time due to inflation as well, which then affects interest rates in all areas of the market.
Businesses Offering Bonds and Stocks
For a business offering both bonds and stocks, it’s important to note that stockholders are considered owners of that particular company, having an equity share in the way the company profits. Bond holders are considered creditors, or lenders, which means that in cases of bankruptcy, bond holders will be paid back before stockholders.
Bonds also usually have a date of termination when the bond reaches maturity, at which point the principal of the loan will be paid back. Stocks, on the other hand, remain purchased until the stockholder sells the shares.
What Is a Balance Sheet?
A company’s balance sheet is a financial document tabulating all of the company's financial information. The balance sheet will report all of a company’s assets — both in cash and as tangible assets — along with its liabilities (money that has been borrowed) and ownership equity (money raised by selling stock for ownership). A balance sheet is a snapshot of the company’s financial state at the time it was taken. Often, companies compare balance sheets over quarterly and annual reviews to watch trends in company money.
For small businesses, the balance sheet is likely to be quite simple: Cash on hand, current inventory and equipment and property make up the assets portion of the balance sheet, and liabilities include any outstanding accounts payable as well as wages, utilities, rent and other loans. Ownership equity represents the amount of money the owners have invested into the business. For larger corporations, the balance sheet can become quite complex.
The key point is that a company’s assets must match its liabilities plus its equity, hence the name "balance sheet". This balancing includes stockholder payouts and company profit, represented by dividends (liabilities owed) or reinvestment.
Bonds Payable and Balance Sheets
Bonds themselves, offered for purchase, act like loans on the balance sheet and thus will appear as liabilities because they are technically loans due. However, bonds create assets — cash on hand, purchased equipment and so on — which is how they balance out on the other side of the balance sheet, as the company sells bonds in order to obtain money for the business. This may appear as bonds payable. Generally, any bonds that will need to be paid within one year are considered current liabilities.
The accounting line "bonds payable" contains the sum of the face value of all issued bonds. This accounting line is considered a long-term account because bonds are usually issued for at least a couple years. The interest paid on these bonds is its own line in the balance sheet, usually recorded as an interest expense. These interest payments come out of the company’s cash assets and are paid to the loan holders.
Bond Pricing and the Market
A company can issue bonds at the market interest rate, but once on the market, these bonds become available at a premium or at a discount. This is due to the secondary market for bonds, meaning there isn’t always a one-to-one ratio between bonds purchased at a face value and the market value of that particular bond.
Bonds offered at a premium are offered with an interest rate higher than the current market rate; this means the company can charge more for them up front. Bonds offered at a discount are offered with a lower interest rate than the market, which means the company must discount them in order to sell them. When this happens, the accounting sheet includes an extra line for premium or discount on bonds payable.
Bond Valuations Over Time
Fluctuations in many different financial markets can affect the actual value of a bond no matter what its face value might be. A company might offer premium bonds on a market because its immediate need for cash is significant, meaning it is willing to offer an interest rate higher than market in order to get investors’ money.
For the investors, this may seem like a bad deal since they’re paying a premium up front on a bond that will only yield the face value after it matures. However, they have the advantage of the higher interest rate over the life of the bond to make up for it. For example, an investor may be willing to pay $125 for a $100 bond if the interim interest payments will be high enough to make up for that amount over time.
What Are Discount and Premium Bonds?
In terms of discounts on bonds payable, investors will get a discount on the original price of the bond and in return get interest over the lifetime of the bond as well as the face value of the bond once it matures. For the investor, this may seem like a great idea because paying $80 for a bond that will return $100 plus its interest seems ideal. Companies are likely to offer bonds at a discount when they’re in financial stress and need to get their hands on money. The initial discount is intended to make up for the lower interest rate payout over time.
Keep in mind that this involves the interaction of a number of interest rates and projections, and both the company and the investor are hoping to play the market in a way that benefits both of them. In cases where the market price changes the value of the bonds issued — written on the bonds payable line in accounting — this is represented with the additional line for premiums on bonds payable or discount on bonds. The company needs to consider this value change as an additional asset or an additional liability since they are still responsible for interest payments and the payback of principal at the end of the bond’s lifetime.