In this case, the bond holder essentially assumes the same role as a bank lending a 30-year mortgage to a home buyer. Much like the bank receiving regular payments over the life of the mortgage loan, the bond holder receives regular payments of both principal and interest until the bond reaches maturity. In other words, a discount on bond payable means that the bond was sold for less than the amount the issuer will have to pay back in the future. When a bond is issued at a premium, the carrying value is higher than the face value of the bond.
For issuers, bonds can be a way to provide operating cash flow, fund capital investments, and finance debt. Bonds are generally thought to be lower risk than discount on bonds payable stocks, which makes them a popular choice among many investors. And for companies issuing a bond, bond amortization can prove to be considerably beneficial.
- 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.
- The bond discount is also used in reference to the bond discount rate, which is the interest used to price bonds via present valuation calculations.
- This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.
- Bonds payable with terms exceeding one year are classified as long-term liabilities and the portion of the bonds payable which fall due within 12 months of the balance sheet date are be classified as current liabilities.
Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Bondholders receive only $6,000 every 6 months, whereas comparable investments yielding 14% are paying $7,000 every 6 months ($100,000 x .07). The difference between the face value of the bonds ($100,000) and the cash ABC Corporation receives ($98,000) is $2,000. Browse all our upcoming and on-demand webcasts and virtual events hosted by leading tax, audit, and accounting experts.
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. 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.
Bond Discount with Straight-Line Amortization
At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 . A bond is sold at a discount when the coupon rate (the interest rate stated on the bond) is less than the prevailing market interest rates for similar bonds. In other words, investors would demand a discount on the purchase price to compensate for the lower interest payments they would receive.
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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. It is important to understand the nature of the https://business-accounting.net/ account. In effect, the discount should be thought of as an additional interest expense that should be amortized over the life of the bond.
Straight-Line Amortization of Bond Discount on Annual Financial Statements
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 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.
The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account. 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 . 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.
If the prevailing market interest rate is above the stated rate, bonds will be issued at a discount. Conversely, if the prevailing interest rate is below the stated rate, bonds will be issued at a premium. Discount amortizations must be carefully documented as they are likely to be reviewed by auditors. The effective-interest method to amortize the discount on bonds payable is often preferred by auditors because of the clarity the method provides. A bond issued at a discount has its market price below the face value, creating a capital appreciation upon maturity since the higher face value is paid when the bond matures.
Just prior to issuing the bond, a financial crisis occurs and the market interest rate for this type of bond increases to 10%. If the corporation goes forward and sells its 9% bond in the 10% market, it will receive less than $100,000. When a bond is sold for less than its face amount, it is said to have been sold at a discount. The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount.
The Interest is usually paid back in a series of payments over several years (usually, semi-annually) and is called the Yield or a Coupon payment. Discounts also occur when the bond supply exceeds demand when the bond’s credit rating is lowered, or when the perceived risk of default increases. Conversely, falling interest rates or an improved credit rating may cause a bond to trade at a premium.
This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. A bond that is issued at a discount is a bond that has been issued for less than the par value of the bond. The difference between the par value and the purchase price is referred to as the «discount.»
