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.
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.