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Accounting for Bonds Issued at a Discount

At the end of 2018, the balance in the Discount on Bonds Payable account is $5,000. It looks like the issuer will have to pay back $104,460, but this is not quite true. If the bonds were to be paid off today, the full $104,460 would have to be paid back.

  • Bondholders receive only $6,000 every 6 months, whereas comparable investments yielding 14% are paying $7,000 every 6 months ($100,000 x .07).
  • In the future, even the bonds are converted, it will increase the stock price which will benefit the current shareholders as well.
  • First, we will explore the case when the stated interest rate is
    equal to the market interest rate when the bonds are issued.
  • When the situation changes and the
    bond is sold at a discount or premium, it is easy to get confused
    and incorrectly use the market rate here.
  • It becomes more complicated when the stated rate and the market rate differ.

There are several types of bonds such as zero-coupon bonds, convertible bonds, high-yield bonds, and so on. The bond types vary by features carried by the bond such as the interest rate, frequency of coupon payments, maturity date, attached warrants, and so on. Before jumping to detail, let’s understand the infographics basic concept of the bond. The bondholders have the right to receive interest as stated on the bond certificate as well as the principal at the maturity date. For private companies issuing bonds, measures must be taken to ensure that potential investors understand the risks involved in their investment.

Which of these is most important for your financial advisor to have?

The recent downturn in the housing market has seen many debtor defaults that have led to bank foreclosures on homes across the country. The interest expense determination is calculated using the
effective interest amortization
interest method. Under the effective-interest method, the interest
expense is calculated by taking the Carrying (or Book) Value
($104,460) multiplied by the market interest rate (4%). The amount
of the cash payment in this example is calculated by taking the
face value of the bond ($100,000) multiplied by the stated
rate. When performing these calculations, the rate is adjusted for
more frequent interest payments.

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. The normal balance of the bond premium account is on the credit side which is the opposite of the bond discount account. Hence, we need to debit the bond premium account in order to remove the remaining unamortized amount of the bond premium from the balance sheet. Of course, it may also be because we want to properly manage cash flows as a result of issuing the bonds. For example, we may issue bonds at a premium in which we will receive more cash than issuing at face value.

  • Bondholder may decide to convert bonds to equity share at the maturity date when the share price increase.
  • Recall from the discussion in
    Explain the Pricing of Long-Term Liabilities that one way
    businesses can generate long-term financing is by borrowing from
    lenders.
  • The accounting treatment for the issuance of bonds depends on whether the bonds are issued at par, a discount, or a premium.
  • There are other possibilities that can be much more complicated and beyond the scope of this course.
  • In this journal entry, the bond premium account is recorded as a liability that is added to the carrying value of the bonds payable on the balance sheet.

This amount must be amortized over the life of bonds, it is the balancing figure between interest expense and interest paid to investors (Please see the example below). At the maturity date, bonds carry amount must be equal to bonds par value. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the market rate is equal to the contract rate, the bonds will sell at their face value.

Using Present Value to Determine Bond Prices

On the other hand, issuing bonds at a discount means that the cash we receive is less than the face value of the bonds. When we issue a bond, we may issue it at face value, at a discount, or at a premium. This is usually based on the market interest rate and the risk that our bonds expose to as well as our reputation on the market. Bondholder may decide to convert bonds to equity share at the maturity date when the share price increase.

Financial Accounting

Since we originally credited Bond Premium when the bonds were issued, we need to debit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received more for the bonds than face value, but it is only paying interest on $100,000. The bond discount account in this journal entry is a contra account to bonds payable on the balance sheet, in which its normal balance is on the debit side. And the amount recorded here is the difference between the cash received from issuing the bonds and the face value of the bonds.

Bonds Issue at Par Value Example

Hence, the carrying value of the bonds payable on the balance sheet equals the face value of issued bonds. Assume that a corporation issues $100 million of bonds payable at an annual interest rate of 5%. The bonds are offered when the market interest rate is 5.1% and there was no accrued interest. The corporation also incurred $1 million of bond issue costs which were paid from bonds’ proceeds. A final point to consider relates to accounting for the interest
costs on the bond. Recall that the bond indenture specifies how
much interest the borrower will pay with each periodic payment
based on the stated rate of interest.

At this stage, the bond issuer would pay the maturity value of the bond to the owner of the bond, whether that is the original owner or a secondary investor. Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of accounting standards. With two exceptions, bonds payable are primarily the same under the two sets of standards. ABC Company will record the journal entries for the interest payment yearly. Since we have used the straight-line amortization method, the accounting entry will be the same every year.

A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. Ask a question about your financial situation providing as much detail as possible. The result is that there is a zero balance in the Interest Payable account and a $4,000 balance in the Interest Expense account. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

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