Discount on bonds payable definition

a discount on bonds payable

Discount on bonds payable (or bond discount) occurs when a corporation issues bonds and receives less than the bonds’ face or maturity amount. The root cause of the bond discount is the bonds have a stated interest rate which is lower than the market interest rate for similar bonds. The investors want to earn a higher effective interest rate on these bonds, so they only pay $950,000 for the bonds. The $50,000 amount is recorded in a Discount on Bonds Payable contra liability account. Over time, the balance in this account is reduced as more of it is recognized as interest expense.

One is zero-percent financing, which is essentially an interest-free loan. This saves borrowers money because they do not have to pay interest on their loans, which can amount to quite a savings. Another incentive car manufacturers may offer is a rebate, which is an up-front reduction off the purchase price, similar to a coupon for a food purchase.

When a bond is issued at a discount, the carrying value is less than the face value of the bond. When a bond is issued at par, the carrying value is equal to the face value of the bond. Accountants have devised a more precise approach to account for bond issues called the effective-interest method. Be aware that the more theoretically correct effective-interest method is actually the required method, except in those cases where the straight-line results do not differ materially. Effective-interest techniques are introduced in a following section of this chapter.

The second way to amortize the discount is with the effective interest method.
In this case, the corporation is offering a 12% interest rate, or a payment of $6,000 every six months, when other companies are offering an 11% interest rate, or a payment of $5,500 every six months.
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This is essentially paying them the $5,000 difference in interest up front since it will still pay bondholders the full $100,000 face amount at the end of the five-year term.
Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.

Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022. 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. Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision.

The actual interest paid out (also known as the coupon) will be higher than the expense. The balances of both current and long-term liabilities are presented in the liabilities section of the balance sheet at the end of each accounting period. When a company has a significant number of liabilities, they are typically presented in categories for clearer presentation. As mentioned previously, a financial statement that organizes its liability (and asset) accounts into categories is called a classified balance sheet. To compensate for the fact that the corporation will pay out $5,000 more in interest, it will charge investors $5,000 more to purchase the bonds and will collect $105,000 instead of $100,000. This is essentially collecting the $5,000 difference in interest up front from investors and essentially using it to pay them the higher interest rate over time.

Discount on Bonds Payable with 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). Next, let’s assume that just prior to offering the bond to investors on January 1, the market interest rate for this bond increases to 10%. The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate.

At that point, the carrying value of the bond should equal the bond’s face value. If a $1,000,000 bond issue promises to pay interest of 8% per year and the bond market demands 8.125%, the bonds will sell for less than $1,000,000. The difference between the $1,000,000 of face value and the amount the bond market is willing to pay is the discount on bonds payable. 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.

A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. By doing so, investors earn a greater return on their reduced investment. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold.

a discount on bonds payable

The total of each liability category appears in the far-right column of the classified balance sheet, and the sum of these totals appears as total liabilities. The following four examples show bonds at both a discount and a premium that are called at both a gain and a loss. As with the sale of fixed assets or investments, it is important to note that any gain or loss when bonds are repaid early is incurred on a transaction that is outside of what occurs in normal business operations.

4.6 Calling Bonds

Notice on the ledger at the right below that each time the end-of-year adjusting entry is posted, the credit balance of the Premium on Bonds Payable decreases. As a result, the carrying amount decreases and gets closer and closer to face amount over time. There are four journal entries that relate to bonds that are issued at a premium. The carrying amount can be thought of as “what the bond is worth” at a given point in time.

Compare the contract rate with the market rate since this will impact the selling price of the bond when it is issued. The people or companies who purchase bonds from a corporation are called bondholders, and they are essentially lending their money as an investment. The reason bondholders lend their money is because they are paid interest by the corporation on the amount they lend throughout the term of the bond. Bondholders do not become owners of a corporation like stockholders do. When a bond is issued at a premium, the carrying value is higher than the face value of the bond.

What is the Amortization of Discount on Bonds Payable?

To compensate for the fact that the corporation will pay out $5,000 less in interest, it will charge investors $5,000 less to purchase the bonds and collect $95,000 instead of $100,000. This is essentially paying them the $5,000 difference in interest up front since it will still pay bondholders the full $100,000 face amount accounting scandals at the end of the five-year term. In return the corporation will pay the bondholders interest every six months and, at the end of the term, repay the bondholders the face amount. The number of payments bondholders will receive in the future from the corporation is always twice the number of years in the term plus 1.

discount on bonds payable definition

Assume the investors pay $9,800,000 for the bonds having a face or maturity value of $10,000,000. The difference of $200,000 will be recorded by the issuing corporation as a debit to Discount on Bonds Payable, a debit to Cash for $9,800,000, and a credit to Bonds Payable for $10,000,000. The amount of the discount is a function of 1) the number of years before the bonds mature, and 2) the difference in the bond’s stated interest rate and the market’s interest rate. Calling bonds – A journal entry is recorded when a corporation redeems bonds early. Redeeming bonds – A journal entry is recorded when a corporation redeems bonds.

That is similar to paying more than carrying amount to redeem a bond, and that is a loss. A loss is similar to an expense, except it involves a transaction that is not directly related to the business’ operations. Redeeming bonds is not a corporation’s primary line of business, so these transactions are non-operational. A bond’s contract rate of interest may be equal to, less than, or more than the going market rate. This same journal entry for $6,000 is made every six months, on 6/30 and 12/31, for a total of 10 times over the term of the five-year bond.

A corporation often needs to raise money from outside sources for operations, purchases, or expansion. Investors contribute cash to the business and are issued stock in return to recognize their shares of ownership. As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) https://www.kelleysbookkeeping.com/your-third-stimulus-check-can-be-seized-here-s/ that was implicit in the pricing of the bonds. For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4, interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412).

Discount on bonds payable definition

Discount on Bonds Payable with Straight-Line Amortization

4.6 Calling Bonds

What is the Amortization of Discount on Bonds Payable?

discount on bonds payable definition

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Discount on Bonds Payable with Straight-Line Amortization

4.6 Calling Bonds

What is the Amortization of Discount on Bonds Payable?

discount on bonds payable definition

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