Usually, though, the amount is material, and so is amortized over the life of the bond, which may span a number of years. In this latter case, there is nearly always an unamortized bond discount if bonds were sold below their face amounts, and the bonds have not yet been retired. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.
Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different. If the amounts of interest expense are similar under the two methods, the straight‐line method may be used. The journal entries made by Lighting Process, Inc. to record its issuance at par of $10,000 ten‐year bonds with a coupon rate of 10% and the semiannual interest payments made on June 30 and December 31 are as shown. The bond’s issuer can always elect to write off the entire amount of a bond discount at once, if the amount is immaterial (e.g., has no material impact on the financial statements of the issuer). If so, there is no unamortized bond discount, because the entire amount was amortized, orwritten off, in one gulp.
For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page.
What is the approximate value of your cash savings and other investments?
Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision. The format of the journal entry for amortization of the bond discount is the same under either method of amortization – only the amounts recorded in each period will change. This topic is inherently confusing, and the journal entries are actually clarifying. Notice that the premium on bonds payable is carried in a separate account (unlike accounting for investments in bonds covered in a prior chapter, where the premium was simply included with the Investment in Bonds account). 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. The discount of $3,851 is treated as an additional interest expense over the life of the bonds.
Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, issued on July 1 when the market interest rate is 10%. The entry to record the issuance of the bonds increases (debits) cash for the $9,377 received, increases (debits) discount on bonds payable for $623, and increases (credits) bonds payable for the $10,000 maturity amount. Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long‐term liability section of the balance sheet.
Bonds Issued at a Discount Example: Carr
Both of these statements are true, regardless of whether issuance was at a premium, discount, or at par. After the payment is recorded, the carrying value of the bonds payable on the balance sheet increases to $9,408 because the discount has decreased to $592 ($623–$31). The bonds would have been paying $500,000 semi annually rather than the $520,000 they would receive with the current market interest rate of 5.2%. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period.
The premium account balance of $1,246 is amortized against interest expense over the twenty interest periods. Unlike the discount that results in additional interest expense when it is amortized, the amortization of premium decreases interest expense. The total interest expense on these bonds will be $10,754 rather than the $12,000 that will be paid in cash. If a bond is issued at a premium or at a discount, the amount will be amortized over the years through to its maturity. The actual interest paid out (also known as the coupon) will be higher than the expense. One simple way to understand bonds issued at a premium is to view the accounting relative to counting money!
How does a bond issuer benefit from issuing a bond at a discount?
The difference is known by the terms discount on bonds payable, bond discount, or discount. A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors.
Reducing this account balance in a logical manner is known as amortizing or amortization. Since a bond’s discount is caused by the difference between a bond’s stated interest rate and the market interest rate, the journal entry for amortizing the discount will involve the account Interest Expense. If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10%), Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity).
Bonds Issued At A Premium
This amount will then be amortized to Bond Interest Expense over the life of the bonds. A basic rule of thumb suggests that investors should look to buy premium bonds when rates are low and discount bonds when rates are high. Because premium bonds typically provide higher coupon payments, the biggest risk is that they could be called before the stated maturity date. As the table shows, the issue price is composed of the present value of the maturity payment of $100,000 discounted at 7% for 10 periods, and the present value of semi-annual cash interest payments of $6,000 ($100,000 x .06), also discounted at 7%. The unamortized debit balance in the Discount on Bonds Payable contra liability account will decrease as it is amortized (i.e., allocated) to Interest Expense over the life of a bond, until it reaches a nil balance when the bond is finally redeemed. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis.
- When a bond is sold for less than its face amount, it is said to have been sold at a discount.
- The difference between the par value and the purchase price is referred to as the “discount.”
- The bonds would have been paying $500,000 semi annually rather than the $520,000 they would receive with the current market interest rate of 5.2%.
- Conversely, if the prevailing interest rate is below the stated rate, bonds will be issued at a premium.
- The entry to record the issuance of the bonds increases (debits) cash for the $11,246 received, increases (credits) bonds payable for the $10,000 maturity amount, and increases (credits) premium on bonds payable for $1,246.
- The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors.
These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year. Gain unlimited access to more than 250 productivity Templates, CFI’s full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more. 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.
The root cause of the bond discount is the bonds have a stated interest rate which is lower than the market interest rate for similar bonds. The bonds have a term of five years, so that is the period over which ABC must amortize the discount. When we issue a bond at a premium, we are selling the bond for more than it is worth. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable. Just like with a discount, the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond.
Discount on Bonds Payable with Straight-Line Amortization
Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest indirect cost definition and meaning check. Another way to consider this problem is to note that the total borrowing cost is increased by the $7,722 discount, since more is to be repaid at maturity than was borrowed initially. Therefore, the $4,000 periodic interest payment is increased by $772.20 of discount amortization each period ($7,722 discount amortized on a straight-line basis over the 10 periods), producing periodic interest expense that totals $4,772.20.
When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond). The difference between the amount received and the face or maturity amount is recorded in the corporation’s general ledger contra liability account Discount on Bonds Payable.
Based on this effective rate, the bonds would be issued at a price of 92.976, or $92,976. The debit balance in the Discount on Bonds Payable account will gradually decrease as it is amortized to Interest Expense over their life. The balance recorded in the account Discount on Bonds Payable becomes lower over the life of the bond as the amount is amortized to the account Bond Interest Expense. This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) that was implicit in the pricing of the bonds.
Since these bonds will be paying the investors less than the market rate of interest ($300,000 semiannually instead of $305,000), the investors will pay less than $10,000,000 for the bonds. The premium or discount on bonds payable is the difference between the amount received by the corporation issuing the bonds and the par value or face amount of the bonds. If the amount received is greater than the par value, the difference is known as the premium on bonds payable. If the amount received is less than the par value, the difference is known as the discount on bonds payable. The interest expense is amortized over the twenty periods during which interest is paid. Amortization of the discount may be done using the straight‐line or the effective interest method.
For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4, interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412). However, due to the matching concept, this cost of $7,024 cannot be expensed when the bonds are issued but must be written off over the life of the bond. Emilie is a Certified Accountant and Banker with Master’s in Business and 15 years of experience in finance and accounting from corporates, financial services firms – and fast growing start-ups.