There are several ways to retire bonds. These include repayment of the bond at maturity, early extinguishment of the debt before maturity, and conversion of the bond into common stock.

Accounting for Retirement of Bonds

When bonds are repaid at maturity, the journal entry is straightforward. Bonds Payable is debited and Cash is credited.

No problems arise with discounts or premiums because they have been amortized to zero by the time of the last interest payment just prior to maturity.

Sinking Fund

To ensure the repayment of the principal, some bond agreements require that the issuing corporation create and maintain a sinking fund.

This is a collection of cash or other assets (e.g., marketable securities) that is set apart from the firm’s other assets and is used only for a specified purpose.

The sinking fund is a type of fund that is generally placed under the control of a trustee or agent who is independent of the entity that established the fund.

The issuing corporation makes periodic payments to its bond sinking fund. These monies are then invested by the trustee and eventually are used to pay the interest and principal of the bond.

The number of periodic payments to the fund is based on the expected return that the trustee can earn on the assets in the fund.

The sinking fund is shown under the investment section on the balance sheet of the issuing corporation. The accounting procedure regarding interest expense recognition and other aspects of bonds is not affected by the existence of a bond sinking fund.

Frequently Asked Questions

What does a bond sinking fund mean?

A bond sinking fund is a fund set aside by the issuer in order to retire bonds when they mature. When investors purchase a bond, they generally look forward to receiving their interest payments in addition to the repayment of the face value of the security on its maturity date. However, if no reservation has been made to retire the bond at maturity, such as a sinking fund (or "pre-funding"), then the issuer can default on its obligation to make timely repayment.

What does sinking fund do?

When an investor purchases a bond, they expect to receive interest payments and also get back their principal when the bond matures. However if no reservation has been made to retire the bond at maturity (which is also known as "pre-funding"), and if the issuer defaults on its obligation to make timely repayment, then it can result in a default. A sinking fund refers to the collection of cash or other assets set apart from the firm's other assets which are used only for a specified purpose.

How is a sinking fund different from the bond's issue price?

A sinking fund is generally placed under the control of a trustee or agent who is independent of the entity that established the fund. The amount, which represents a part of the capital raised by a corporation through the sale of various securities to investors, is known as the issue price.

What is the relationship between bond sinking fund and interest expense?

A bond sinking fund, apart from being a reserve of cash or assets for debt repayment purposes, is also a form of pre-funding which isn't taxed by the Internal Revenue Service (IRS). The term "pre-funding" means that income taxes are not applicable to the principal repayments.

What is a bond sinking fund account?

The bond sinking fund account or simply "sinking fund," pertains to an account created by a firm in order to record the portion of their annual Financial Statement that is a repayment of a bond at maturity, which is done either through cash or other assets. The investment in the sinking fund is also tax free until maturity.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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