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.
How are bond premium and discount calculated?
Interest rates are the primary factor that affects bond pricing. If a bond is issued at a certain rate and subsequently the bond market’s interest rates fall, the higher-interest bond looks better than it did before. As a result, the price of the product rises.
The entire bond premium is the bond’s market value less its face value. For example, if a 10-year bond pays 6% interest and has a $1,000 face value but costs $1,080 on the market, the bond premium is the difference of $80 between the two values.
You’ll need to know the bond’s coupon rate and the yield to maturity depending on the price you actually paid to figure out how much of your premium you may amortize each year. The yield to maturity on the 10-year bond in the example above is around 5%. Because you’re paying more than face value for the bond, this is less than the advertised coupon rate of 6%.
Is a current liability a discount on bonds payable?
When a company prepares a bond to be issued/sold to investors, it may need to factor in the interest rate that will appear on the bond’s face and in its legal contract. Assume that the company issues a $100,000 bond with a 9% interest rate. A financial crisis happens just before the bond is issued, and the market interest rate for this sort of bond rises to 10%. If the company proceeds with the sale of its 9% bond in the 10% market, it will receive less than $100,000. A bond is considered to have been sold at a discount when it is sold for less than its face value. The difference between the amount received (excluding accrued interest) and the bond’s face amount is known as the discount. The terms “discount on bonds payable,” “bond discount,” and “discount” are used to describe the difference.
Assume a corporation prepares a 9% $100,000 bond dated January 1, 2020 in early December 2019 to demonstrate the discount on bonds payable. Until the bond matures on December 31, 2024, interest payments of $4,500 ($100,000 x 9% x 6/12) will be due on June 30 and December 31 each year.
Let’s now say that the market interest rate on this bond rises to 10% immediately before it is offered to investors on January 1st. Rather of revising the bond paperwork to reflect the market interest rate, the firm decides to sell the 9% bond. Because the corporation is selling its 9% bond in a market that is wanting 10%, the corporation will receive less than the bond’s face value.
Assume that on January 1, 2020, the 9 percent bond is sold in the 10% market for $96,149 plus $0 accrued interest to demonstrate the accounting for bonds payable issued at a discount. The following is the journal entry that the corporation will make to document the bond sale:
Because it will have a debit balance, the account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra liability account. The account Bonds Payable will always show a discount on Bonds Payable on the balance sheet. In other words, if the bond is a long-term liability, the balance sheet will show both Bonds Payable and Discount on Bonds Payable as long-term liabilities. The book value or carrying value of the bonds is the sum of these two accounts, or the net of these two accounts. The book value of this bond on January 1, 2020 is $96,149 (the $100,000 credit balance in Bonds Payable minus the $3,851 debit amount in Discount on Bonds Payable).
Discount on Bonds Payable with Straight-Line Amortization
The sum in the account Discount on Bonds Payable must be lowered to zero over the life of the bond. Amortizing or amortization is the process of reducing the account amount in a rational manner. Because the difference between a bond’s stated and market interest rates causes the discount, the journal entry for amortizing the discount will use the account Interest Expense.
The bond discount of $3,851 in our example arises from the firm getting only $96,149 from investors but needing to pay them $100,000 when the bond matures. Over the life of the bonds, the $3,851 discount is recognized as an additional interest charge. Straight-line amortization occurs when the same amount of bond discount is recorded each year. The straight-line amortization in this case would be $770.20 ($3,851 divided by the bond’s 5-year duration).
Straight-Line Amortization of Bond Discount on Annual Financial Statements
If a company only publishes yearly financial statements on December 31, bond discount amortization is frequently reflected when the company makes semiannual interest payments. In our case, the straight-line technique will result in the following journal entries for 2020:
The total interest expense for 2020 will be $9,770 (two semiannual interest payments of $4,500 each + two semiannual bond discount amortizations of $385 each). The entries for the year 2020 are shown in the T-account for Interest Expense:
The T-account below shows how the balance in Discount on Bonds Payable will decrease over the bond’s 5-year tenure.
The bond’s book value will increase from $96,149 on the date the bond was issued to $100,000 at maturity as the bond discount is amortized:
Straight-Line Amortization of Bond Discount on Monthly Financial Statements
The monthly amount of bond discount amortization under the straight-line technique will be $64.18 ($3,851 of bond discount divided by the bond’s life of 60 months) if the corporation releases monthly financial statements. During the year 2020, the 12 monthly journal entries for bond interest and bond discount amortization, as well as the entries for the June 30 and December 31 semiannual interest payments, will result in the following 14 entries:
If all of the bonds remain outstanding, the journal entries for the future years will be similar.
What is the difference between bond premium and bond discount?
A premium bond has a coupon rate that is greater than the market rate for the maturity and credit grade of the bond. A discount bond, on the other hand, has a coupon rate that is lower than the current interest rate for the maturity and credit grade of the bond.
This distinction may be clarified by using an example. Assume you had an older bond, one that was originally a 10-year bond when you purchased it five years ago. You want to sell this bond right now because it has a 5% coupon rate. Because there are five years until the bond matures, when you sell it, it will compete on the market with new bonds having a five-year maturity.
Assume that those new bonds have a coupon rate of 3%, which is comparable to yours in terms of credit quality. Investors will “bid up” the price of your bond until it has a yield to maturity of 3%, which is comparable to the market interest rate. Your bond will trade at a premium to its par value as a result of this bidding-up process. Your buyer will pay a higher price for the bond, and the premium they pay will cut the bond’s yield to maturity to match what is now available. A bond discount, on the other hand, would increase rather than decrease the yield to maturity.
As a result, the yield to maturity of a bond is the great equalizer (YTM). The current market price, par value, coupon interest rate, and time to maturity are all factors in the YTM calculation. All coupon payments are also assumed to be reinvested at the same rate as the bond’s current yield. YTM is a precise bond return calculation that allows investors to compare bonds with varying prices, maturities, and coupons. We wish to buy bonds with the highest YTM based on maturity, credit worthiness, and industry equivalencies.
Which of the following statements about a bond discount is true?
Which of the following statements about a bond discount is TRUE? – On the balance sheet, a discount on bonds due is added to the bonds payable total and shown with long-term liabilities.
How should the discount on payable bonds be shown in the financial statements premium on payable bonds?
The discount (premium) on bonds payable should be represented as a straight deduction from (addition to) the face amount of the bond in the balance sheet. Both of these accounts are liability valuation accounts.
What is the usual discount balance on bonds payable?
Because it differs from the standard credit balance, discount on bonds payable is a contra liability account. Its default balance is negative. To determine the carrying amount, the discount on bonds payable account is included. 13.
What exactly is a bond 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.
Where can you get a good discount rate?
The discount rate, also known as the discount factor, is a percentage that depicts the time worth of money for a certain cash flow. You’ll need to know the maximum interest rate you could earn on a similar investment elsewhere to determine a discount rate for a cash flow. Divide 1 by the interest rate plus 1 to get the discount factor for a cash flow one year from now. If the interest rate is 5%, for example, the discount factor is 1 divided by 1.05, or 95%.