Discount on Bonds Payable: Unwrapping Discounts on Bonds Payable: The Contra Account Perspective

Just make sure whether your teacher is going to focus on straight line, effective interest method, or both. But for now, let’s focus on the straight the discount on bonds payable account line method, just so you can kind of see how this works. And a lot of the principles between straight line and effective are very similar. And through interest expense is where that discount will disappear, okay?

It is the long term debt which issues by the company, government, and other entities. It must be classified as long-term liability unless it going to mature within a year. Usually financial statements refer to the balance sheet, income statement, statement of comprehensive income, statement of cash flows, and statement of stockholders’ equity. When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond.

• The existing bond’s semiannual interest of $4,500 is $500 less than the interest required from a new bond.
• The bond is issued on February 1 at its par value plus accrued interest.
• Discount bonds payable are the bonds issued at a discount by the companies and happen when the coupon rate is less than the prevailing market interest rate.
• When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond.

For example, if a company issues a bond with a face value of $1,000 for $950, it would record a “Discount on Bonds Payable” of $50. Over time, this $50 would be amortized and recognized as interest expense, thereby increasing the total interest expense the company recognizes over the life of the bond. Investors, on the other hand, are concerned with the yield to maturity (YTM), which reflects the total return anticipated on a bond if held until it matures. The amortization of the discount increases the YTM, as the investor effectively pays less for the bond upfront and receives the full face value at maturity.

So the journal entry is debit bonds payable and credit cash paid to investors. Company C issue 9%, 3 years bond when the market rate is only 8%, par value is $ 100,000. When the coupon rate is higher than effective interest rate, the company can sell bonds at a higher price.

Journal Entry for Bonds

• When a bond is issued at a discount, the carrying value is less than the face value of the bond.
• In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life.
• The systematic reduction of a loan’s principal balance through equal payment amounts which cover interest and principal repayment.
• To illustrate the premium on bonds payable, let’s assume that a corporation prepares to issue bonds with a maturity amount of $10,000,000 and a stated interest rate of 6%.

To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. Because the bonds have a 5-year life, there are 10 interest payments (or periods). The periodic interest is an annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the tenth period. The 8% market rate of interest equates to a semiannual rate of 4%, the 6% market rate scenario equates to a 3% semiannual rate, and the 10% rate is 5% per semiannual period. The bonds have a term of five years, so that is the period over which ABC must amortize the discount.

Always use the market interest rate to discount the bond’s interest payments and maturity amount to their present value. The present value of a bond is calculated by discounting the bond’s future cash payments by the current market interest rate. In our example, the bond discount of $3,851 results from the corporation receiving only $96,149 from investors, but having to pay the investors $100,000 on the date that the bond matures.

Bond Principal Payment

If however, the market interest rate is less than 9% when the bond is issued, the corporation will receive more than the face amount of the bond. The amount received for the bond (excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on bonds payable, bond premium, or premium. Assume that a corporation prepares to issue bonds having a maturity amount of $10,000,000 and a stated interest rate of 6% (per year). However, when the bonds are actually sold to investors, the market interest rate is 6.1%.

Over time, this discount must be amortized, which can affect financial statements and tax obligations. Investors, on the other hand, may view bond discounts as an opportunity to realize a gain upon maturity or sale if the market value of the bond increases. The discount also affects the yield-to-maturity, with the actual yield being higher than the stated coupon rate due to the lower purchase price. In the financial world, bond discounts are a fascinating phenomenon that occur when the market interest rate exceeds the coupon rate of the bond, resulting in the bond being sold for less than its face value. This discount reflects the market’s assessment of risk and the time value of money, and it has significant implications for both issuers and investors. From the issuer’s perspective, a discount on bonds payable can be seen as an opportunity to raise capital at a lower upfront cost, although it does imply higher interest expenses over time.

Bond Interest and Principal Payments

Using the straight-line method, the company would amortize $10 each year ($50 discount / 5 years). However, with the effective interest rate method, the amortization would vary each year, increasing as the carrying amount of the bond approaches the face value. However, the journey of a bond from issuance to maturity is influenced by market dynamics that can affect its price and yield. Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision.

An existing bond’s market value will decrease when the market interest rates increase.The reason is that an existing bond’s fixed interest payments are smaller than the interest payments now demanded by the market. Let’s illustrate this scenario with a corporation preparing to issue a 9% $100,000 bond dated January 1, 2024. The bond will mature in 5 years and requires interest payments on June 30 and December 31 of each year until December 31, 2028. The bond is issued on February 1 at its par value plus accrued interest. Throughout our explanation of bonds payable we will use the term stated interest rate or stated rate. Usually a bond’s stated interest rate is fixed or locked-in for the life of the bond.

The investors want to earn a higher effective interest rate on these bonds, so they only pay $950,000 for the bonds. The $50,000 amount is recorded in a Discount on Bonds Payable contra liability account. Over time, the balance in this account is reduced as more of it is recognized as interest expense. In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31. The entries for 2024, including the entry to record the bond issuance, are shown next. Amortizing a bond discount is a critical process in the realm of finance, as it pertains to the gradual reduction of the discount on bonds payable over the life of the bond.

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As an entrepreneur and investor, I prioritize construction and collaboration. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Study the following illustration, and observe that the Premium on Bonds Payable is established at $8,530, then reduced by $853 every interest date, bringing the final balance to zero at maturity. In other words, one percentage point is equal to 100 basis points. The difference between an interest rate of 6.5% and 6.75% is 25 basis points. Using debt (such as loans and bonds) to acquire more assets than would be possible by using only owners’ funds.

Present Value of the Bond’s Maturity Amount

In the face value bonds, the cash interest was our interest expense. Unfortunately, when we’ve got a discount or a premium, our interest expense is going to be different from the actual cash interest that we paid, and that’s because we’re amortizing the discount or the premium. So let’s go ahead and see how we’re going to amortize this discount. We know that we’re going to have a credit to cash on July 1, when we have this 6 months of interest we’re paying, well, we’re going to pay off 2,250 in cash. Because we had a credit to bonds payable and then the discount which was lowering the value of bonds payable down to 47,000, we had that $3,000 value. And since it had a debit balance before, we get rid of it with credits.

Bonds Issued at Face Value between Interest Dates

As the market rate is also 6%, so company can issue bonds at par value. Callable bonds are bonds that give the issuing corporation the right to repurchase its bonds by paying the bondholders the bonds’ face amount plus an additional amount known as the call premium. A bond’s call price and other conditions can be found in a bond’s contract known as the indenture.

So that’s an increase to our liabilities of 300 and then our interest expense, well that’s a decrease to equity, right? So the decrease to equity 2,550, the increase to liabilities of 300, that equals the decrease to assets of 2,250. When a company issues bonds at a discount, it sells the bonds for less than their face value. This discount impacts the financial statements in several ways, reflecting the economic reality that the company will ultimately pay more in interest than the amount it initially received from bondholders. The discount on bonds payable is considered a contra account, which means it has a balance that is opposite of the account it relates to—in this case, bonds payable. Over the life of the bonds, the discount is amortized and gradually reduces the carrying amount of the bond to its face value.

A bond discount is relevant when a bond issues at less than face value. Notice that under both methods of amortization, the book value at the time the bonds were issued ($104,100) moves toward the bond’s maturity value of $100,000. The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.