Bonds Payable at Discount
A bond is said to be issued at discount when it is sold for less than its face value. When the interest rate stated on a bond is lower than the market interest rate, the is overvalued at its face value because it is offering a return less than the market return. In order to induce investors to buy the bond, the issuer is forced to reduce the price of the bond below its face value.
Let's consider Company D which has initiated issue of 1,000 $100-par bonds having a maturity of 5 years and coupon of $8 per year. When it was finally ready to issue the bond on 1 July 20X2, the market interest rate had soared to 10%.
Accounting treatment for issuance of a bond at discount
Inventors would not be willing to buy Company D bond for $100. The fair value of the bond 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 will be able to raise a total of $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:
| Cash | 92,420 | |
| Discount on bonds payable | 7,580 | |
| Bonds payable | 100,000 |
Bonds payable is reported on the statement of financial position net of the discount i.e. 92,420 ($100,000 face value less discount of $7,580).
| Bonds payable - Face value | $100,000 |
| Less: Bond discount | ($7,580) |
| Bonds payable - net | $92,420 |
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%). Under the effective interest method, the interest expense equals the product of the bond carrying amount and market interest rate which in this case equals $9,242 ($92,420 multiplied by 10%).
Bond discount amortization during the first year equals the excess of interest expense over interest payment i.e. $1,242 ($9,242 - $8,000).
The first interest payment is recognized as follows:
| Interest Expense | 9,242 | |
| Interest Payable | 8,000 | |
| Discount on bonds payable | 1,242 |
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.
At the end of first year, the bonds payable shall appear on the statement of financial position as follows:
| Bonds payable - Face value | $100,000 |
| Less: Bond discount ($7,580 - $1,242) | ($6,338) |
| Bonds payable - net | $93,662 |
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 payable | 100,000 | |
| Cash | 100,000 |
by Obaidullah Jan, ACA, CFA and last modified on