Discount on Bonds Payable Definition, Example Journal Entries
“Discount on Bonds Payable” is a concept related to bonds that are issued at a price less than their face value. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models what is discount on bonds payable for all types of industries.
However, issuing debt securities, such as bonds, is another way organizations can borrow funds. Issuing securities is borrowing in that the organization receives cash which must be repaid to the lender at a later date. We explore the concept of Discount on Bonds Payable, how it is calculated, and why companies choose to issue bonds at a discount. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them. Likewise, at the end of the maturity of the bond, the $12,000 of the bond premium will become zero.
Straight-line method
These debt securities are issued with the promise of repaying the principal, also known as the face value, at a specified maturity date. The allure of bonds lies in the interest payments, or coupons, which are paid at regular intervals as compensation for the investor’s capital. In the case of discounted bonds, lower yields can be concerning for bondholders as it diminishes the income they receive from their investment.
- In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium.
- The $4,100 more than the bond’s face amount is referred to as Premium on Bonds Payable, Bond Premium, Unamortized Bond Premium, or Premium.
- We can amortize the discount on bonds payable with the straight-line method by dividing the discount amount by the maturity period of the bond.
- In accounting, the bond discount or the discount on bonds payable is considered a borrowing cost in addition to the contractual interest of the bond.
Likewise, the interest expense from the issuance of the bonds at discount will be higher than the contractual interest in the bond. Consider a company that issues a $1,000,000 bond with a 5-year maturity and a 10% coupon rate at a price of $950,000, reflecting a $50,000 discount. The company will pay $100,000 annually in cash interest (10% of $1,000,000), but the interest expense recognized in the financial statements will be higher due to the amortization of the discount. This means that although the company pays $100,000 in cash, the interest expense could be, for example, $110,000 after accounting for the amortization. This additional $10,000 is the effective interest rate’s reflection of the true cost of borrowing.
Straight-Line Amortization of Bond Discount on Annual Financial Statements
For issuers, the chosen method of amortization can affect reported earnings and tax liabilities. Investors typically monitor the carrying value of bonds as it reflects the market’s perception of the issuer’s creditworthiness. A discount on bonds payable might suggest that the issuer had to offer a higher yield to attract buyers, possibly due to perceived risk. Over time, as the discount is amortized, investors can gauge the actual cost of borrowing for the issuer and reassess the investment’s risk and return profile. When a bond is issued at a price lower than its face value, it is said to be sold at a discount. This bond discount represents the difference between the amount paid for the bond and its stated face value or par value.
Bonds will have a stated rate of interest dictating the value of the periodic interest payments. However, market interest rates change frequently, so the interest rate stated on the bond may be different from the current interest rate at the time of bond issuance. Therefore, bonds sold below the current market value are issued at a discount while bonds issued above the current market value are at a premium. In the realm of strategic financial management, the concept of leveraging discounts on bonds can be a game-changer for both issuers and investors. Bonds are typically issued at a discount when the interest rate they offer is lower than the prevailing market rates.
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The discount on bonds payable is treated as a contra-liability account, which means it reduces the bonds payable balance on the balance sheet. Over the life of the bonds, the discount is amortized, and the carrying value of the bonds payable increases. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0. 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.
Combining the Present Value of a Bond’s Interest and Maturity Amounts
The $4,100 more than the bond’s face amount is referred to as Premium on Bonds Payable, Bond Premium, Unamortized Bond Premium, or Premium. To calculate the present value of the semiannual interest payments of $4,500 each, you need to discount the interest payments by the market interest rate for a six-month period. This can be done with computer software, a financial calculator, or a present value of an ordinary annuity (PVOA) table. Let’s examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%.
Summary of the Effect of Market Interest Rates on a Bond’s Issue Price
This is particularly attractive in a low-interest-rate environment or when the investor believes that the market has overestimated the issuer’s credit risk. For instance, consider a bond with a face value of $1,000, issued at a discount to sell for $950. If this bond matures in five years, the investor stands to gain a $50 return in addition to any coupon payments, which may result in a yield higher than the bond’s stated coupon rate. When a company issues bonds at a discount, it means that the bonds are sold for less than their face value.
Balance Sheet
- And when we redeem the $500,000 bonds back at the end of their maturity, we can reduce the carrying value of bonds payable to zero by simply debiting the bonds payable account and crediting the cash account.
- The discount ensures that the bond’s effective yield aligns with the market rate, making it competitive for investors.
- As such, it’s a cornerstone of bond valuation and a testament to the dynamic nature of financial instruments.
- On the income statement, the discount is amortized over the life of the bond, leading to higher interest expense each period.
- The bond coupon rate is the interest rate that the issuer pays to the holder of the bond (the investor).
- This account is a contra-liability that reduces the carrying value of bonds payable on the balance sheet.
If the company issues the bond at a coupon rate, which is less than the market interest rate, the investor won’t buy the entity’s bonds because it will bring a lower return on his investment compared to the market. Further, in such a scenario, the entity will face challenges raising money through bonds. The balance of the discount on bonds payable account will be transferred to the interest expense through the amortization in each accounting period and it will become zero at the end of the bond maturity. In this journal entry, the discount on bonds payable is a contra account to the bonds payable in which its normal balance is on the debit side. Likewise, this account will be classified in the liability section of the balance sheet. The discount on bonds payable account is a contra-liability account that reduces the face value of bonds payable when they are issued at a price below face value.
What is Discount on Bonds Payable?
For example, a business may issue a 5 year bond on which it will pay interest to the investor. At the end of the 5 year period on the maturity date, the business will need to pay the investor the market price for the bond. If the bond terms stipulated that the business can buy back the bonds at any time (usually at a premium), bond retirement can take place before maturity.
The journal entries for the years 2025 through 2028 will be similar if all of the bonds remain outstanding. Finally, the interest expense due to the purchaser of the bond is expensed as incurred on the income statement. 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. Suppose some investors purchase these bonds that will be worth $20,000,000 at maturity for $19,600,000.