Accounting for Investments in Bonds

(The above bond image is in the public domain)

Investments in bonds can generate a multitude of accounting treatments and may be puzzling to accounting students. The purpose of this article is to provide a brief overview of these possibilities.  There are several ways investments in bonds can be valued and reported:

Fair Value Option—Accepted accounting principles (“GAAP”) now allows fair value accounting for bonds. Unrealized gains and losses are recognized[1] at each balance sheet date.  These gains and losses flow through the income statement, and the carrying value of the bonds are adjusted accordingly.

The alternative accounting treatment allows bonds to be classified in three different ways, with three different accounting policies and two potential locations on the balance sheet:

  1. A trading security.  If it is the intent of management to actively trade its bond portfolio (or even that particular bond) fair value accounting is used. The bonds are adjusted to fair value at each balance sheet date and unrealized gains and losses are recognized and flow through the income statement. The trading security is a current asset in a classified balance sheet. There is little expectation the bond will be retained for a significant period of time.
  2. A held-to-maturity (“HTM” security).  Bonds classified as held to maturity are recorded at amortized cost. It must be management’s intent to hold the bond until its maturity date and the company must have the ability to do so. A company in a desperate financial situation may not be able to demonstrate the ability to hold a bond to its maturity date, resulting in fair value accounting.  An HTM security will be classified as either a current or long-term investment depending on its maturity date.  HTM accounting is available only for securities with a maturity date. If the company can hold the bond until maturity, there is no risk of market fluctuations.  Since the company plans to hold the bond to maturity there is negligible risk of loss due to market fluctuation.[2]
  3. A security available for sale-This is a bond that doesn’t fall into either of the above categories. These bonds are recorded at fair value, but any unrealized gain or loss is recorded in Other Comprehensive Income (“OCI”) on the balance sheet net of deferred taxes.[3] Available for sale securities may be either current assets or long-term investments depending on the anticipated liquidation date.

As you already see, where the bond appears on a classified balance sheet and how it is accounted for depends on the accounting policy of the company and the intent of management. Good internal control requires management to have an investment and accounting policy for bond investments. If the fair value option is not chosen, the independent auditors will usually ask management to make a representation[4] the company can and will hold a certain security until its maturity date.

Let’s review some of the basic accounting for bonds. Bond values fluctuate inversely to interest rate. As interest rates rise, bond price decrease.  As interest rates decline, bond prices increase. This makes sense since bonds will trade at the prevailing interest rate. No one will buy a bond yielding 7% for face value if the going rate for that maturity and quality of bond is 9%. The bond will have to trade at a discount. Conversely, bonds paying a higher interest rate than the going rate will trade at a premium.  A bond paying 10% will fetch a premium in a trade if the market for that maturity and type of bond is paying 9%.  

First, we will look at an example of the fair value option and the trading security accounting. Suppose you own a bond you have purchased for $1,000 and the current fair value is $900 at December 31, 2019.  The journal entry to recognize the unrealized loss is:

Dr.  Unrealized loss                         100

Cr.  Investment in bonds                             100

Subsequently, interest rates drop and the fair value of the bond recovers. At March 31, 2020, the bond is now trading at $1,100. The journal entry to recognize the unrealized gain is:

Dr.  Investment in bonds                  200

Cr.       Unrealized gain                              200

The unrealized gain and loss would be recorded in the income statement for the period the market fluctuation occurred.

Now assume the same facts as above, except the bond is classified as a security available for sale and the combined federal and state income tax rate is 30%:  The accounting entries would be:

Dr. Other Comprehensive Income   100

Cr.  Investment in bonds                            100

To record the change in fair market value of securities available for sale.

Dr.   Deferred tax asset                     30

Cr.  Other Comprehensive income              30

To record the deferred tax benefit associated with the unrealized loss, calculated as the effective federal and state tax rate of 30% times the unrealized loss.  

Finally, if the bond is classified as an HTM security, amortized cost is used to account for the investment.[5]  Let’s look at how a bond purchased at a discount is accounted for.  Suppose a bond having a ten year maturity has a face value of $1,000 and a coupon rate of 10% but was issued for $900 due to an increase in interest rates to 11%.  The entry for the purchase of the bond is:

Dr.  Investment in bonds (HTM)      1,000

Cr.  Bond discount                                            100

Cr.  Cash                                                            900

To record the purchase of a bond at a discount.

The bond will appear on the balance sheet as a long-term investment since it has a ten-year maturity and will appear net of the discount for a net carrying value of $900. 

At the end of the first year, interest on the bond will be accrued and the following entry will need to be made:

Dr.  Bond discount                                     10

Cr.   Interest income                                                   10

To amortize bond discount over the life of the bond.

Let’s understand what is happening here.  The investor bought a bond for $900 that will pay 10% interest per year.  At maturity, the investor will receive not the $900 paid for the bond, but the face value of the bond, $1,000. That additional $100 needs to spread over the ten-year life of the bond, thereby resulting in an additional $10 of interest income per year. A similar process occurs for bonds purchased at a premium. [6]  

On a separate issue, a bond portfolio is subject to interest rate risk.  There are various methods of minimizing this risk such as the use of duration measures and bond immunization techniques. These issues are covered in most investment courses. Bond options are also available as well. These are derivative securities and are accounted for as such.  Bond options qualify for hedge accounting. This hedging is typically done with U.S. Treasury security options as it is unlikely there are specific options for specific corporate or municipal bonds.

Test Your Knowledge

  1. True or False. Independent auditors should obtain representations from management about the organization’s ability to hold a bond until its maturity.
  2. True or False.  Independent auditors should obtain other evidence about management’s intentions with HTM securities by reviewing prior sales of HTM securities, reading board minutes, and discussing the matter with the appropriate company officers.
  3. True or False.  The straight-line method of bond discount amortization is the preferred method under GAAP.
  4. True or False.  Unrealized gains and losses for available for sale securities are recorded in OCI.
  5. True or False. Management’s intentions are a critical element in accounting for bond investments.

Answers appear on the next page.

Answers

  1. True.  It is appropriate for management to have this matter included in the management representation letter.  
  2. True.  Management representations are a form of audit evidence, albeit a weak one.  Additional evidence from other sources should always be sought.   
  3. False. The effective interest method is the preferred method of amortizing discount under GAAP.  The straight-line method can only be used if it is not materially different than the effective interest method.  The effective interest method is preferred by GAAP since it keeps a level effective interest rate. The straight-line method is easy to apply and demonstrate.  
  4. False.  A trick question! Yes, unrealized gains and losses on securities available for sale are recorded in OCI, but the deferred tax effect is also recorded there as well.   
  5. True.  Auditors and financial managers need to approach this with care.  All available evidence about management’s intentions should be scrutinized.    

[1] Remember, an unrealized gain is seldom a recognized gain for tax purposes. In certain cases, even a realized gain (a disposal for example) may not cause recognition for tax purposes. In financial accounting, unrealized gains or losses may cause recognition in the financial statements.

[2] Credit losses are handled separately and not included in this article.

[3] It is permissible to show the deferred tax effect for the total items in the OCI account or they can be separated for each item as done in this article.

[4] This will be done in the management representation letter, a mandatory procedure for an independent audit. Other steps such as reading the board of director minutes or making inquiries of management can shed additional light on management’s intent.

[5] This article presumes prior knowledge of this subject from the appropriate intermediate accounting course.  It is presented here as a “refresher” on the topic.  For the purposes of this article, simple straight-line amortization is demonstrated.  GAAP requires the use of the effective interest method, which is beyond the scope of this article.  

[6] Taxation of bond premiums and discounts are not discussed here.