Issuance of Bonds Payable at Discount

A bond is issued at discount when it is sold for less than its par value. When the interest rate stated on a bond is lower than the market interest rate the investor the investor consider the bond to be overvalued because it is offering a less than market return. In order to induce the investors to buy the bond the issuer is forced to reduce the price of the bond.

Example

Company D has printed 1,000 bonds of $100 par value having a maturity of 5 years and annual coupon of $8 per year. When it was finally ready to issue the bond on 1 July 2012 the interest rate prevailing in the market has soared to 10%.

Accounting treatment for issuance at discount

Inventors would not be willing to buy a bond for $100 because it is overvalued at 8%. The correct value keeping in view the market interest rate of 10% is $92.42 calculated as follows:

Price of Bond = 8% × $100 × 1 − (1 + 10%)-5+$100= $92.42
10%(1 + 10%)5

Company D would be able to raise only $92,420 from the bond with face value of $100,000. It has issued them at a discount of $7,580 ($100,000 minus the proceeds of $92,420).

Company D will record the issuance by the following journal entry:

Cash92,420
Discount on Bonds Payable7,580
Bonds Payable100,000

Bonds payable is reported on the balance sheet net of the discount i.e. 92,420 ($100,000 face value less discount of $7,580).

Recognition of interest on bonds issued at discount

Interest expense in case of bonds issued at discount has two components: one related to the payment of interest based on the coupon rate and second relates to amortization of discount. Discount is amortized using either straight line method or the effective interest method.

In case of Company D interest paid in cash equals $8,000 ($100,000 multiplied by the stated coupon rate of 8%). Assuming straight line amortization the yearly amortization expense should be $1,516. Total interest expense is hence $9,516 which is recorded as follows:

Interest Expense9,516
Interest Payable8,000
Discount on Bonds Payable1,516

Amortization of discount reduces the balance in the contra account to bonds payable and results in an increase in carrying amount of bonds payable. Amortization reduces the balance in discount on bonds payable account such that at the maturity the bonds payable's carrying amount is equal to its face value.

Retirement of bonds issued at discount

At maturity the bonds' carrying amount is equal to their face value. Company D would pay off the face value and record the event as follows:

Bonds Payable100,000
Cash100,000

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork