# Bond Discount: Definition, Example, Vs Premium Bond

On maturity, the book or carrying value will be equal to the face value of the bond. Both of these statements are true, regardless of whether issuance was at a premium, discount, or at par. 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 format of the journal entry for amortization of the bond discount is the same under either method of amortization – only the amounts recorded in each period will change. Assume the investors pay \$9,800,000 for the bonds having a face or maturity value of \$10,000,000.

• Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases.
• Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination of the specific characteristics of a bond issue and the actual issuance of the bond.
• The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable.

To further explain, the interest amount on the \$1,000, 8% bond is \$40 every six months. Because the bonds have a 5-year life, there are 10 interest payments (or periods). The periodic interest is an annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the tenth period. The 8% market rate of interest equates to a semiannual rate of 4%, the 6% market rate scenario equates to a 3% semiannual rate, and the 10% rate is 5% per semiannual period. The premium or discount on bonds payable is the difference between the amount received by the corporation issuing the bonds and the par value or face amount of the bonds.

## Where the Premium or Discount on Bonds Payable is Presented

The amount of the cash payment in this example is calculated by taking the face value of the bond (\$100,000) and multiplying it by the stated rate (5%). Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense and the cash paid to bondholders. The amount of the discount amortization is simply the difference between the interest expense and the cash payment. Since we originally debited Bond Discount when the bonds were issued, we need to credit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received less for the bonds than face value but is paying interest on the \$100,000.

• Remember that the bond payable retirement debit entry will always be the face amount of the bonds since, when the bond matures, any discount or premium will have been completely amortized.
• The periodic interest payments to the buyer (investor) will be the same over the course of the bond.
• This means that the bond terms like interest, payback period, and principle amount are set months in advance before they are issued to the public.

Notice on the ledger at the right below that each time the end-of-year adjusting entry is posted, the debit balance of the Discount on Bonds Payable decreases. As a result, the carrying amount increases and gets closer and closer to face amount over time. 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 at the end of the five-year term. Since the total interest payments are equal, the corporation’s bond is competitive with other bonds on the market and the bond can be issued at face amount. Here is a comparison of the 10 interest payments if a company’s contract rate equals the market rate.

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

When the same amount of bond discount is recorded each year, it is referred to as 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. 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.