The difference between a bond’s face value and the decreased price at which it was sold by the issuer is known as the discount on bonds payable. When investors need to earn a greater effective interest rate than the bond’s stated interest rate, this occurs. The discount is held in a contra liability account, which is linked to and offsets the bonds payable account. The discount is amortized to interest expense throughout the remaining life of the bond, resulting in an increase in interest expense for the issuer over the bond’s life. As the discount is amortized over time, it shrinks in size until the bond is redeemed, when it approaches a zero balance.
What factors lead to a bond payable discount?
When a bond’s stated interest rate is less than the bond market’s interest rate, a discount on bonds payable arises.
If a bond issue offers to pay an annual interest rate of 8% and the bond market demands 8.125 percent, the bonds will sell for less than $1,000,000. The discount on bonds payable is the difference between the face value of $1,000,000 and the amount the bond market is willing to pay.
The amount of the discount is determined by two factors: 1) the number of years until the bonds mature, and 2) the difference between the bond’s stated and market interest rates.
What is a bond payable discount?
- The amount by which the market price of a bond is less than the principal amount payable at maturity is known as the bond discount.
- Because the larger face value is paid when the bond matures, a bond issued at a discount has a market price below the face value, resulting in capital appreciation.
- Bonds trade at a discount for a variety of reasons: fixed-coupon bonds trade at a discount as interest rates rise, while zero-coupon bonds and short-term bonds are sometimes issued at a bond discount when supply exceeds demand.
A discount on bonds payable arises under what conditions of bond issuance? What circumstances lead to the emergence of a premium on bonds payable?
When does a discount on BP occur as a result of bond issuance? When a bond is issued, under what circumstances does a premium on BP arise? When investors demand a rate of interest higher than the rate listed on the bonds, a discount on bonds payable occurs.
What circumstances lead to the emergence of a premium on bonds payable?
When bonds payable are issued for an amount larger than their face or maturity amount, premium on bonds payable (or bond premium) arises. The reason for this is that the bonds have a stated interest rate that is greater than the market rate for identical bonds.
Why are discount bonds issued?
A discount bond is a bond that is currently trading in the secondary market for less than its par value. When a bond’s coupon rate is lower than the current interest rate, it is said to be trading at a discount. Investors will pay less for a bond with a lower coupon rate than the current rates because the upfront discount compensates for the lower coupon rate.
Why is a contra obligation discount on bonds payable?
Because it is a liability account with a debit balance, the Discount on Bonds Payable account is a contra account. Some accountants refer to both the Discount on Bonds Payable and the Premium on Bonds Payable as auxiliary accounts, while others refer to both as valuation accounts.
How do you keep track of bond discounts?
If the bonds were issued with a discount or premium, the amount must be amortized over the life of the bonds. If the quantity is little, a straight-line calculation can be used. Calculate the periodic amortization using the effective interest method if the amount is significant or if a higher level of accuracy is desired.
If the issuer received a discount on bonds payable, the periodic entry is a debit to interest expense and a credit to discount on bonds payable, which increases the issuer’s overall interest expense. The entry is a debit to premium on bonds payable and a credit to interest expenditure if there was a premium on bonds payable; this reduces the issuer’s overall interest expense.
The amortization of bond issuance costs is recorded as a credit to financing expenditures and a negative to other assets on a quarterly basis.
Quizlet: What is the balance in the discount on bonds payable account?
Interest expense is represented by the account Discount on Bonds Payable, which will be amortized over the bond’s life. Bondholders have the right to vote for the board of directors when a corporation sells bonds.
Bonds may trade at a discount or premium for which of the following reasons?
When an investor buys a bond, he or she expects the bond issuer to pay interest. The bond’s value, on the other hand, is likely to rise or fall in response to changes in market interest rates. When interest rates rise, the bond’s value decreases. As a result, the bond must be sold at a discount. As a result, the term “discount bond” was coined. The discount takes into account the bond’s risk as well as the bond issuer’s creditworthiness.
A discount bond is one that is sold at a lower rate than the current market rate. Investing in a bond at a discount means paying a lower price than the bond’s face value. It does not, however, imply that it will provide superior returns than other bonds.
Let’s look at a bond with a $1,000 face value as an example. The bond is regarded to be offered at a discount if it is offered at $970. The bond is regarded to be offered at a premium if it is priced at $1,030. Bonds are traded on the secondary market, where their prices fluctuate according to market conditions. When the bond matures, however, the par value will be returned to investors.
Why Bond Prices Fluctuate During Trading
When a new bond is issued, it comes with a stated coupon that details how much interest bondholders will get. A bond having a par value of $1,000 and a coupon rate of 3%, for example, will pay $30 in annual interest. If interest rates fall to 2%, the bond’s value will increase, and the bond will trade at a premium. If interest rates rise to 4%, the bond’s value will plummet, and it will trade at a discount.
Bond prices must vary in response to changing interest rates so that their YTM is equal to or nearly equivalent to the YTM of new bond issues. Because bond prices and YTMs move in opposite directions, this is the case. When interest rates are higher than the coupon rate on a bond, bond prices must fall below the par value (discount bond) to bring the YTM closer to the interest rate. Bond prices climb above par value when interest rates fall below the coupon rate. Bonds will trade at a premium during periods when interest rates are consistently falling, bringing the YTM closer to the falling interest rates. Similarly, if interest rates rise, more bonds will trade at a discount to par value.
Bond issuer’s risk of default
When bondholders see the issuer as having at a higher danger of defaulting on their obligations, they may only be ready to purchase the bonds at a discount.
Fluctuating interest rates
When interest rates climb faster than the bond’s coupon rate, the bond trades at a discount. As a result, they are able to make a reasonable profit on their investment.
Credit rating review
An issuer’s credit rating may be lowered by a bond rating agency. As a result of the lower rating, the bond will trade at a discount to compensate investors for the higher risk.
Pros and Cons of Investing in Discount Bonds
As long as the bond issuer does not default, discount bonds have a good chance of rising in value. Even though the investors initially paid less than the bond’s par value, if they keep their bonds until maturity, they will be paid an amount equal to the bond’s par value.
Discount bonds may have a higher chance of default based on the issuer’s financial situation. After exhausting all other options for raising finance, a corporation may decide to issue bonds. If a bond rating agency believes the likelihood of the issuer defaulting on its present commitments has increased, it may reduce the issuer’s rating.