Accrued Interest

Since the corporation issuing a bond is required to pay interest, and since the interest is paid on only two dates per year, the interest on a bond will be accruing daily. This means for each day that a bond is outstanding, the corporation will incur one day of interest expense and will have a liability for the interest it has incurred but has not paid. If the corporation has issued a 9% $100,000 bond, then each day it will have interest expense of $24.66 ($100,000 x 9% x 1/365).

If the corporation issues monthly financial statements, then each month it needs to report $750 ($100,000 x 9% x 1/12) of interest expense. The corporation usually does this with the following monthly adjusting entry:

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While the issuing corporation is incurring interest expense of $24.66 per day on the 9% $100,000 bond, the bondholders will be earning interest revenue of $24.66 per day. With bondholders buying and selling their bond investments on any given day, there needs to be a mechanism to compensate each bondholder for the interest earned during the days a bond was held. The accepted technique is for the buyer of a bond to pay the seller of the bond the amount of interest that has accrued as of the date of the sale. For example, if a 9% $100,000 bond has a date of January 1, 2013 and it is sold on January 31, 2013, the buyer of the bond is required to pay the seller of the bond one month's interest amounting to $750 ($100,000 x 9% x 1/12).

Bonds Issued at Par with No Accrued Interest

If a corporation issues a bond on January 1, 2013 and the bond has a date of January 1, 2013 there will be no accrued interest on the bond when it is issued. If the investor pays the corporation the face amount of the bond, the bond is said to have been issued at par or at 100—meaning 100% of the bond's face value plus any accrued interest. (As we will see later, it is possible for a new bond to be issued after the date of the bond—and therefore to have accrued interest. In addition a bond might be sold by the issuing corporation for more or less than its face value.)

Let's assume that on January 1, 2013 a corporation issues a 9% $100,000 bond at its face amount. The bond is dated January 1, 2013 and requires interest payments on each June 30 and December 31 until the bond matures at the end of 5 years. Each semiannual interest payment will be $4,500 ($100,000 x 9% x 6/12). The corporation is also required to pay $100,000 of principal to the bondholders on the bond's maturity date of December 31, 2017.

Since the bond was issued/sold for 100% of its face amount and since there is no accrued interest to be paid by the buyer of the bond, the issuing corporation will make the following journal entry:

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The following timeline shows the future cash payments that the corporation must make to the bondholders:

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Journal Entries for Interest Expense - Annual Financial Statements

If the corporation issuing the above bond has an accounting year ending on December 31, the corporation will incur twelve months of interest expense in each of the years that the bonds are outstanding. In other words, under the accrual basis of accounting, this bond will require the issuing corporation to report Interest Expense of $9,000 ($100,000 x 9%) per year.

If the corporation issues only annual financial statements, the interest expense can be recorded at the time of its semiannual interest payments, as shown in the following journal entries for the year 2013:

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Journal Entries for Interest Expense - Monthly Financial Statements

If the corporation issues monthly financial statements, it must report interest expense of $750 ($100,000 x 9% x 1/12) on each of its monthly income statements. It must also report a current liability on its balance sheet for the amount of interest that it has incurred but has not yet paid. This is accomplished by recording an accrual adjusting entry at the end of each month. In addition there will be an entry on June 30 and on December 31 for the required interest that was actually paid to the bondholders. The 14 journal entries pertaining to the corporation's bond interest during the year 2013 will be:

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The journal entries for the years 2014 through 2017 will have the same accounts and amounts.