Blog

As with the straight‐line method of amortization, at the maturity of the bonds, the discount account’s balance will be zero and the bond’s carrying value will be the same as its principal amount. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization . When a corporation is preparing a bond to be issued/sold to investors, it may have to anticipate the interest rate to appear on the face of the bond and in its legal contract.

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 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.

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.

Where the Premium or Discount on Bonds Payable is Presented

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.

This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment. The premium account balance represents the difference (excess) between the cash received and the principal amount 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.

What Is a Discount on Bonds Payable?

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.

• The difference of $200,000 will be recorded by the issuing corporation as a debit to Discount on Bonds Payable, a debit to Cash for $9,800,000, and a credit to Bonds Payable for $10,000,000.
• The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check.
• This means there would be a difference of $400,000 between the amount these investors paid for the bond and what they will be worth at maturity.
• To illustrate the issuance of bonds at a discount, suppose that on 2 January 2020, Valenzuela Corporation issues $100,000, 5-year, 12% term bonds.

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.

Journal Entry for Discount on Bonds Payable

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.

• 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.
• Therefore, the $4,000 periodic interest payment is reduced by $853 of premium amortization each period ($8,530 premium amortized on a straight-line basis over the 10 periods), also producing the periodic interest expense of $3,147 ($4,000 – $853).
• Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount.

To illustrate the issuance of bonds at a discount, suppose that on 2 January 2020, Valenzuela Corporation issues $100,000, 5-year, 12% term bonds. The difference is the amortization that reduces the premium on the bonds payable account. It is also true for a discounted bond, however, in that instance, the effects are reversed. See Table 3 for interest expense and carrying value calculations over the life of the bond using the straight‐line method of amortization . Discount on bonds payable occurs when a bond’s stated interest rate is less than the bond market’s interest rate. The corporation that issues the bonds will record the $400,000 difference by debiting the account Discount on Bonds Payable and also debiting cash for $19,600,000 and crediting Bonds Payable in the amount of $20,000,000.

Amortization of Discount on Bonds Payable

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.

But, when the company sold the bonds to some investors, there was a market interest rate of 5.2%. For an example of a bond discount, suppose that a company is preparing to issue some bonds that, at maturity, will be worth $20,000,000. This $31,470 must be expensed over the life of the bond; uniformly spreading the $31,470 over 10 six-month periods produces periodic interest expense of $3,147 (not to be confused with the actual periodic cash payment of $4,000).

As the premium is amortized, the balance in the premium account and the carrying value of the bond decreases. The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account. See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium. At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 . As the discount is amortized, the discount on bonds payable account’s balance decreases and the carrying value of the bond increases. The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account.

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 what is posting in accounting 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.

Watch It: Bonds issued at a premium

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!

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.

Spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20 (not to be confused with the periodic cash payment of $4,000). To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. 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.

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.

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.