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.

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The amount of the premium amortization is simply the difference between the interest expense and the cash payment. Another way to think about amortization is to understand that, with each cash payment, we need to reduce the amount carried on the books in the Bond Premium account. Since we originally credited Bond Premium when the bonds were issued, we need to debit the account each https://quick-bookkeeping.net/ 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. In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31.

Amortized Bonds Payable

To calculate interest expense for the next semiannual payment, we subtract the amount of amortization from the bond’s carrying value and multiply the new carrying value by half the yield to maturity. To calculate interest expense for the next semiannual payment, we add the amount of amortization to the bond’s carrying https://bookkeeping-reviews.com/ value and multiply the new carrying value by half the yield to maturity. Bonds issue at par value mean that the issuer sell bonds to investors at par value. Bonds may also be issued during a calendar year rather than on January 1. They may also be redeemed during a calendar year rather than on December 31.

Because some people will be attracted to buy because of lower payments over time and others will be interested due to the lower up- front purchase price. The deals are designed to appeal to different types of people with different buying preferences. A bond’s contract rate of interest may be equal to, less than, or more than the going market rate. A corporation typically pays interest to bondholders semi-annually, which is twice per year.

For example, one hundred $1,000 face value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value (or principal https://kelleysbookkeeping.com/ amount) of the bonds. Computing long-term bond prices involves finding present values using compound interest. Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class.

Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the market rate of interest on their investment. Some investors prefer to pay full price and have higher interest payments every six months. Others are attracted by paying less up front and being paid back the full face amount at maturity and are willing to live with the lower semi-annual interest payments. Both deals are equal in value but are structured to appeal to different markets. The issue price is the amount of cash collected from bondholders when the bond is sold. Cash is debited for the amount received from bondholders; the liability (debt) from bonds increases for the face amount.