In this example, the straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond). The premium or discount is to be amortized to interest expense over the life of the bonds. To illustrate the issuance of bonds at a discount, suppose that on 2 January 2020, Valenzuela Corporation issues $100,000, 5-year, the ecommerce guide to bookkeeping 12% term bonds. If the prevailing market interest rate is above the stated rate, bonds will be issued at a discount. Conversely, if the prevailing interest rate is below the stated rate, bonds will be issued at a premium. Discount on bonds payable occurs when a bond’s stated interest rate is less than the bond market’s interest rate.
- The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest.
- The price investors pay for a given bond issue is equal to the present value of the bonds.
- When a bond is sold for less than its face amount, it is said to have been sold at a discount.
The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page. 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.
Journal Entry for Discount on Bonds Payable
The discount of $7,024 represents the present value of the $1,000 difference that the bondholders are not receiving over each of the next 10 interest periods (5 years’ interest paid semi-annually). If the discount amount is immaterial, the parent and contra accounts can be combined into a one balance sheet line-item. The debit balance in the Discount on Bonds Payable account will gradually decrease as it is amortized to Interest Expense over their life. 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. This entry records the $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.
- The difference is known by the terms discount on bonds payable, bond discount, or discount.
- When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors.
- If interest dates fall on other than balance sheet dates, the company must accrue interest in the proper periods.
- This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month.
- Each yearly income statement would include $9,544.40 of interest expense ($4,772.20 X 2).
However, due to the matching concept, this cost of $7,024 cannot be expensed when the bonds are issued but must be written off over the life of the bond. The journal entries for the remaining years will be similar if all of the bonds remain outstanding. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Bondholders receive only $6,000 every 6 months, whereas comparable investments yielding 14% are paying $7,000 every 6 months ($100,000 x .07).
Discount on bonds payable definition
Since a bond’s discount is caused by the difference between a bond’s stated interest rate and the market interest rate, the journal entry for amortizing the discount will involve the account Interest Expense. 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. 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.
Accounting for Bonds Issued at a Discount
Premium on bonds payable is a contra account to bonds payable that increases its value and is added to bonds payable in the long‐term liability section of the balance sheet. The central government soon observed the economic advantages of printing paper money, issuing a monopoly right of several of the deposit shops to the issuance of these certificates of deposit. By the early 12th century, the amount of banknotes issued in a single year amounted to an annual rate of 26 million strings of cash coins. By the 1120s the central government officially stepped in and produced their own state-issued paper money (using woodblock printing). Likewise, if interest rates soared to 15%, then an investor could make $150 from the government bond and would not pay $1,000 to earn just $100. This bond would be sold until it reached a price that equalized the yields, in this case to a price of $666.67.By this time, the notes were standardized in appearance and not too different from Federal Reserve Notes.
This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period. This method is required for the amortization of larger discounts, since using the straight-line method would materially skew a company’s results to recognize too little interest expense in the early years and too much expense in later years. It is also the same as the price of the bond, and the amount of cash that the issuer receives.
Thus, if the market rate is 10% and the contract rate is 12%, the bonds will sell at a premium as the result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate is 14% and the contract rate is 12%, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the market rate of interest on their investment. Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest.
At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Essentially, the company incurs the additional interest, amounting to $7,024, at the time of issuance by receiving only $92,976 rather than $100,000. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Each yearly income statement would include $9,544.40 of interest expense ($4,772.20 X 2).
Part 2: Your Current Nest Egg
At the end of the schedule (in the last period), the premium or discount should equal zero. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0. Reducing this account balance in a logical manner is known as amortizing or amortization.
Three years later, the bank went bankrupt, after rapidly increasing the artificial money supply through the large-scale printing of paper money. A new bank, the Riksens Ständers Bank was established in 1668, but did not issue banknotes until the 19th century. The shift toward the use of these receipts as a means of payment took place in the mid-17th century, as the price revolution, when relatively rapid gold inflation was causing a re-assessment of how money worked.
Amortization of the discount may be done using the straight‐line or the effective interest method. Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different. If the amounts of interest expense are similar under the two methods, the straight‐line method may be used. 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.
Straight-Line Amortization of Bond Discount on Annual Financial Statements
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. The market rate fluctuates from day to day, responding to factors such as the interest rate the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and demand for, money. As the discount is amortized, the discount on bonds payable account’s balance decreases and the carrying value of the bond increases.
