This amortization process ensures that the carrying amount of the bonds on the balance sheet aligns with their face value at maturity. There are several reasons why a bond sells at a discount to its face value. First, the current market interest rate is higher than the interest rate being paid by the issuer, so investors pay less for the bond in order to derive a higher effective interest rate on their investment. Second, investors perceive the issuer as being at risk of not redeeming the bonds it has issued, and so are willing to sell their bonds at a reduced price in order to avoid the risk of default. These existing bonds reduce in value to reflect the fact that newer issues in the markets have more attractive rates.

• An analyst or accountant can also create an amortization schedule for the bonds payable.
• To illustrate the issuance of bonds at a discount, suppose that on 2 January 2020, Valenzuela Corporation issues $100,000, 5-year, 12% term bonds.
• Notice that interest expense is the same each year, even though the net book value of the bond (bond plus remaining premium) is declining each year due to amortization.
• When a company has a significant number of liabilities, they are typically presented in categories for clearer presentation.

The carrying value will continue to increase as the discount balance decreases with amortization. When the bond matures, the discount will be zero and the bond’s carrying value will be the same as its principal amount. The discount amortized for the last payment may be slightly different based on rounding. See Table 1 for interest expense calculated using the straight‐line method of amortization and carrying value calculations over the life of the bond.

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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 https://accounting-services.net/bonds-payable/ deals are equal in value but are structured to appeal to different markets. Another possibility is for the corporation to issue bonds, which are also a form of debt.

• Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long‐term liability section of the balance sheet.
• At that point, the carrying value of the bond should equal the bond’s face value.
• The discount will increase bond interest expense when we record the semiannual interest payment.

This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them. In all the previous examples, bonds were issued on January 1 and redeemed on December 31 several years later.

When the market rate of interest is higher than the stated bond rate, the price of the bond must be lowered to equal the difference. Discount on bonds payable occurs when a bond’s stated interest rate is less than the bond market’s interest rate. 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.

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Company

There are times when the contract rate that your corporation will pay is more than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be higher than what investors could receive elsewhere. Since its future interest payments will be higher in comparison to other bonds on the market, the corporation can command a higher amount up front when the bond is issued, and the bond is sold at a premium. This means the corporation receives more cash than the face amount of the bond when it issues the bond. The corporation still pays the face amount back to the bondholders on the maturity date. The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued.

4.2 Bond Transactions When Contract Rate is Less Than Market Rate

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 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. Some investors prefer to pay full price and have higher interest payments every six months.

4.3 Carrying Amount of Bonds Issued at a Discount

You may have heard of ways car manufacturers encourage people to buy vehicles. 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.

What is the Discount on Bonds Payable?

The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the terms discount on bonds payable, bond discount, or discount. 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. 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.

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Effective-interest techniques are introduced in a following section of this chapter. The present value factors are taken from the present value tables (annuity and lump-sum, respectively). Take time to verify the factors by reference to the appropriate tables, spreadsheet, or calculator routine.

In this example the corporation will pay interest on June 30 and December 31. 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%) 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).