Amortizing Premiums and Discounts Financial Accounting

When a company issues bonds to generate cash, bonds payable are recorded and listed as a liability on the company’s balance sheet. The investors paid only $900,000 for these bonds in order to earn a higher effective interest rate. Company A recorded the bond sale in its accounting records by increasing Cash in Bank (debit asset), Bonds Payable (credit liability) and the Discount on Bonds Payable (debit contra-liability). The bond discount is then amortized over the life of the bond, typically through a series of journal entries or by using a bond discount amortization schedule.

The discount on bonds payable occurs when a company issues bonds at a price lower than their face value, typically due to prevailing market interest rates being higher than the bonds’ stated interest rates. The process of recording the amortization of a bond discount involves a debit and a credit entry in the company’s accounting records. The debit is made to the interest expense account, reflecting the increase in cost over the coupon payment due to the amortization. Concurrently, a credit is applied to the discount on bonds payable account, which reduces the discount and increases the carrying value of the bond on the balance sheet.

Discount vs. premium

The entries for 2024, including the entry to record the bond issuance, are shown next. A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period.

What Is the Difference Between the Effective Interest Rate and the Stated Interest Rate?

The total interest expense over the life of the bond is $2,180, which is the difference between the face value and the selling price of the bond. The total coupon payment over the life of the bond is $500, which is 10% of the face value of the bond. The total amortization of the discount over the life of the bond is $1,680, which is the same as the discount at the time of issuance. One of the most important aspects of accounting for debt discount is how to initially recognize and measure the debt instrument. A debt discount arises when a debt is issued at a price lower than its face value or principal amount.

Straight Line Method and Bond Amortization

One of the challenges of accounting for debt issued at a discount is how to report and disclose the relevant information in the financial statements. Debt discount represents the difference between the face value and the issue price of a bond or a note payable. It is considered a contra liability account that reduces the carrying value of the debt. The debt discount must be amortized over the life of the debt using an amortization of discount on bonds payable effective interest method or a straight-line method. The amortization of debt discount affects the interest expense and the net income of the issuer. A business or government may issue bonds when it needs a long-term source of cash funding.

Summary of the Effect of Market Interest Rates on a Bond’s Issue Price

If the cash interest paid is $45,000, the $4,000 difference is the amortized discount for that period. To determine the unamortized discount, one must establish the bond’s initial discount amount and lifespan, then track the systematic amortization of the discount over time. This process shifts the discount from the balance sheet to the income statement, as detailed in the bond amortization schedule. Understanding the unamortized discount on bonds payable is essential for accurate financial reporting and analysis. This figure represents the portion of a bond’s initial discount that has not yet been allocated to interest expense over time, impacting both balance sheets and income statements. When the coupon rate on a bond is lower than the market interest rate, the bond is issued at a discount to par value.

• The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond.
• The principal portion of the bond is recognized as a bond payable in the liabilities section of the balance sheet.
• Bond issuers may use sinking funds to buy back issued bonds or parts of bonds prior to the maturity date of the bond.
• The bond amortization schedule calculator is one type of tvm calculator used in time value of money calculations, discover another at the links below.
• Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline.

On the other hand, if the interest rate stated on the face of a bond is greater than the prevailing market rate on the date of issuance, the bond will be sold at a higher price than the face value. The buyer would receive higher interest payments than what is potentially available on the current market. This is called a bond premium, and would also be recognized on the financial statements of the bond issuer. The debt discount is amortized over the life of the debt using the effective interest method.

Present Value of a Bond’s Interest Payments

The market value of an existing bond will fluctuate with changes in the market interest rates and with changes in the financial condition of the corporation that issued the bond. For example, an existing bond that promises to pay 9% interest for the next 20 years will become less valuable if market interest rates rise to 10%. Likewise, a 9% bond will become more valuable if market interest rates decrease to 8%. When the financial condition of the issuing corporation deteriorates, the market value of the bond is likely to decline as well.

• This is because we paid an amount lower than the face value of the bond at issue date but will get the full face value at maturity.
• One of the advantages of issuing debt at a discount is that it lowers the cash outflow for the issuer, as the interest payments are based on the face value, not the issue price.
• The cumulative effect of these adjustments over time provides a more accurate depiction of the company’s financial health.
• When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond.
• Therefore, the discount is a deferred cost that needs to be accounted for over the bond’s term.

Bonds are generally thought to be lower risk than 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 liability account with a debit balance, which is contrary to the normal credit balance of its parent Bonds Payable liability account. The effective interest rate to call method assumes the bond will be called before its maturity date, and the amortization schedule accelerates to match the shortened life of the bond.

In the journal entries above, it can be seen that cash received in lieu of bonds payable is at a lower price as compared to the actual face value of the bond. The difference between both, the actual cash received as well the face value is debited as a discount offered on bonds payable. Bond discount arises when the rate of return expected in the market on a bond is higher than the bond’s coupon rate.