Amortizing Bond Discount Using the Effective Interest Rate Method

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When issuing bonds, firms are always competing with the prevailing rates; sometimes, a bond can be issued at par, while other times at a discount (as ABC Ltd had to do in our example). Please see our article here to explain when this situation arises and the calculations and journal entries involved. Thus, bonds payable appear on the liability side of the company’s balance sheet. 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%.

  • The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account.
  • This would be more common in a rising interest rate environment than a premium on purchase, which one would see more of in a falling interest rate environment.
  • The premium will decrease bond interest expense when we record the semiannual interest payment.

Based on this effective rate, the bonds would be issued at a price of 92.976, or $92,976. These bond issues aren’t just for the private sector, although corporate bond issues are prevalent. The public and non-government organisation (NGO) sectors also use these debt instruments to raise funds for large projects. For example, governments issue similar types of instruments for capital programs and their growing fiscal deficits.

What is a Discount on Bonds Payable?

Set out below is an effective interest calculation table for the 10 years (20 interest payment period) bonds payable for ABC Ltd. You will see a small rounding error at the end with $57 left of the unamortised discount. This is the bond price that an investor would be prepared to pay for ABC’s $10,000 bonds with a coupon rate of 5 per cent and an equivalent market rate of 8 per cent. 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. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization.

The borrower will pay back the principal to whoever holds the contract on maturity date. Investors are attracted to Bonds Payable for their relative safety compared to equities, as points, lines and curves they offer a fixed income and are often considered less volatile. The creditworthiness of the issuer, expressed through credit ratings, influences the interest rate on the bonds.

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If the bond’s value falls below par, investors are more likely to purchase it since they will be repaid the par value at maturity. To calculate the bond discount, the present value of the coupon payments and principal value must be determined. The bond discount is considered a liability because it represents an obligation of the issuing company. When a company issues bonds at a discount, it means that the bonds are sold for less than their face value. The discount is essentially the difference between the face value of the bonds and the cash proceeds received by the company at the time of issuance.

Introduction to Bonds Payable

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. At issue, you debit cash for the $1.041 million sale proceeds and credit bonds payable for $1 million face value. You plug the $41,000 difference by crediting the adjunct liability account “premium on bonds payable.” SLA reduces the premium amount equally over the life of the bond. In this example, you semi-annually debit the premium on bonds payable by the original premium amount divided by the number of interest payments, which is $41,000 divided by 10, or $4,100 per period. 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.

Accounting for Bonds Issued at a Discount

When the interest rate increases past the coupon rate, bondholders now hold a bond with lower interest payments. A bond sold at par has its coupon rate equal to the prevailing interest rate in the economy. An investor who purchases this bond has a return on investment that is determined by the periodic coupon payments. 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.

The Discount on Bonds Payable serves as a way to adjust the actual cost of borrowing for the issuing company when bonds are sold at a discount, as it effectively increases the interest expense over the bond’s life. 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. In simple words, bonds are the contracts between lender and borrower, the amount of contract depends on the face value. However, the lender can receive the principal before the maturity date by selling contract to the capital market.

The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. For example, assume a company wants to issue a $1,000, 10% bond to the public when the market rate of interest is 12 percent. This would be fine except that the bond market fluctuates everyday just like the stock market. Depending on the current market, investors might be unwilling to earn the interest rates that the bond states. This means that companies can’t issue bonds at the same price that is stated on the bond itself.