Accrual Bond Definition
A bond is a financial instrument issued to a borrower by an investor as a representation of a loan made by the investor. It has details of the principal loan and the periodic interest payments to be made by the borrower. An accrual bond is a type of bond in which the interest is not paid periodically but accrued. The accrued interest is then summed up together with the principal amount of the bond and then paid at maturity.
A Little More on What is an Accrual Bond
Corporations use accrual bonds in raising long-term funds. The bank deposit rates in a certain period, affect the prices of bonds that an enterprise issue in the same period. Usually, the bonds are issued at face value, at a premium or a discount. The enterprises set up for the accrual bond in their books under accounts such as the ‘bond face value,’ ‘the bond discount,’ ‘the bond premium’ and ‘the accrued interest.’ The statements are typically prepared under the subject of accounting for bond issuance, the interest accrued and interest payments.
An enterprise issuing the bonds at face value is required to debit the ‘bank deposits’ together with other subjects in the correct amount received and credit the ‘accrual bonds-par value.’ However, if there is a difference, the enterprise is required to debit the ‘accrual bonds-interest adjustment’ subject.
When interest is accrued using the coupon rate in each period for the bonds issued at face value, the costs and expenses relevant are included following the long-term borrowing principle. The ‘construction in progress,’ ‘finance expenses’ and ‘manufacturing expenses’ are also debited. Unpaid interest resulting from the coupon rate, for the bonds paid in installments and awaiting repayment at the end of the period, is calculated under the ‘payable interest’ subject.
For a repayable bond, unpaid interest arising due to the coupon rate gets accounted under the ‘accrual bonds-Accrued Interest’ account. The calculation that is used to determine the interest costs is included in the relevant costs and expenses following the principles governing long-term loans.
When accrual bond expires, and the company settles the principal plus interest of the bond, it debits the following accounts; ‘accrual bonds – face value,’ ‘accrual bonds – accrued interest,’ and ‘payable interest.’ The company also credits the ‘bank deposits’ account and any other used under the accrual bond.
Sometimes when a bond is issued, the expenses incurred are higher than interest income realized by freezing funds during the period of issuance. When this happens, the difference arising between the costs incurred and the interest income realized is used for fixed assets. This is according to the objective of raising money for the issuance of bonds. It is treated under the principle of capitalization of borrowing costs if it is for the project.
If it is for other purposes, the difference is included in the current financial expenses. This mainly arises if the cost incurred in freezing the interest income realized when releasing the funds, is higher than the issue. The provisions on the capitalization of long-term borrowing costs provide the guidelines to the principle of handling other borrowing costs.
The company issues a convertible corporate bond that has a redemption option. The bond also has the interest compensation supposed to be paid on the redemption date. The interest compensation is the difference arising from the interest paid on the bond and the interest to be paid when the bond redemption period expires. The principal of capitalization of borrowing costs still provides the guidelines on how to treat the accrued interest to be paid from the issue date to the redemption date.
References for Accrual Bond
Academic Research on Accrual Bonds
- The intersection of market and credit risk, Jarrow, R. A., & Turnbull, S. M. (2000). The intersection of market and credit risk. Journal of Banking & Finance, 24(1-2), 271-299. This study explains how much the market and credit risks are closely related and cannot be separated according to economic theory. Standard approaches to credit risk management are thought to have limited value when used in portfolios which contain instruments that have sensitive interest rates and when applied to measure market and credit risk. Also, it is argued that the default risks and the recovery rates uncertainties are not the only determinants of credit spread.
- How does the corporate bond market value capital investments and accruals?, Bhojraj, S., & Swaminathan, B. (2009). How does the corporate bond market value capital investments and accruals? Review of Accounting Studies, 14(1), 31-62. This article investigates if the mispricing of accruals present in equity markets also extends to bond markets. It examines the fact that firms having high operating accruals possess corporate bonds which underperform those of firms which have low operating accruals
- Two-Step Sovereign Debt Restructuring: A Market-Based Approach in a World without International Bankruptcy Law, Bartholomew, E., Liuzzi, A., & Stern, E. (2003). Two-Step Sovereign Debt Restructuring: A Market-Based Approach in a World without International Bankruptcy Law. Geo. J. Int’l L., 35, 859. This study explains various ways that states can use to restructure their debts. It includes market-based solutions and not policies enacted by states.
- Accrual quality, bond liquidity, and cost of debt, Qi, C. Z., Subramanyam, K. R., & Zhang, J. (2010). Accrual quality, bond liquidity, and cost of debt. Working paper. This paper examines how accrual quality affects the bond quality and how this implicates the cost of debt. The paper argues that high accrual quality decreases uncertainty and diminishes information asymmetry and this, in turn, improves liquidity leading to a lower cost of debt.
- Some new bond indexes, Bildersee, J. S. (1975). Some new bond indexes. The Journal of Business, 48(4), 506-525. This article examines various investment performance indexes that have been prepared using returns for the securities of the United States government over many years.
- The role of accruals and cash flows in the corporate bond market, O’Bryan, D., Quirin, J. J., & Berry, K. T. (1999). The role of accruals and cash flows in the corporate bond market. The Mid-Atlantic Journal of Business, 35(4), 189. This study attempts to explain the part played by accruals and cash flows as far as the corporate bond market is concerned.
- Changes in the US financial system and the subprime crisis, Kregel, J. (2008). Changes in the US financial system and the subprime crisis. This article provides a scope of how housing finance in the United States evolved from the 1970s’deregulation of the financial system all the way to the breaking down of the savings and loans industry, the establishment of GSE securitization and the private financial system. It gives a background to the forces that produced the current residential housing finance system, reasons for the present mortgage financing crisis and how the crisis has affected the financial system.
- Factors affecting seasoned corporate bond prices, Boardman, C. M., & McEnally, R. W. (1981). Factors affecting seasoned corporate bond prices. Journal of Financial and Quantitative Analysis, 16(2), 207-226. This paper breaks down the prices of corporate bonds into elements which are associated with the actual price of time, the default risk of the class in which the bond is assigned and the specific risk and features of the bond itself.
- Accounting for bond liabilities, Anton, H. R. (1956). Accounting for bond liabilities. Journal of Accountancy (pre-1986), 102(000003), 53. This article explains the various accounting transactions carried out over the life of the bond
- Accrual Recording of Interest Revisited–Why the SNA must be revised, Hill, P. (1999, September). Accrual Recording of Interest Revisited–Why the SNA must be revised. In Paper presented at the OECD meeting on National Accounts. This paper identifies the various reasons why the System of National Accounts must be revised when it comes to the recording of interests
- Internal liquidity risk in corporate bond yield spreads, Chen, T. K., Liao, H. H., & Tsai, P. L. (2011). Internal liquidity risk in corporate bond yield spreads. Journal of Banking & Finance, 35(4), 978-987. This study elaborates on the importance of internal liquidity risk in corporate credit risk as has been revealed in the recent global financial crisis. A few studies have been examining its impact on bond yield spreads, and their findings suggest that it should be integrated into bond yield spread modeling.
- The Accrual of Corporate Dividends Under the Federal Estate Tax, Lowendes, C. L., & Kramer, R. (1954). The Accrual of Corporate Dividends Under the Federal Estate Tax. U. Pitt. L. Rev., 16, 46. This paper explains how corporate dividends are accrued following the federal estate tax.
Long-Term Bond Returns under Duration Targeting, Leibowitz, M. L., Bova, A., & Kogelman, S. (2014). Long-Term Bond Returns under Duration Targeting. Financial Analysts Journal, 70(1), 31-51. This paper explains how most bonds have a stable duration over time making them ‘duration targeted’ whether implicitly or explicitly. However, the duration targeting is not given much attention.