The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. We then covered using the straight-line and effective interest methods of amortising the discount on bonds payable contra account. As discussed, although they reach the same end of fully amortising the discount balance, the effective method better reflects the firm’s borrowing costs. ABC Ltd wants to raise $1,000,000 from local investors for new machinery it needs to replace existing equipment with. The bonds will be for ten years, paying interest every six months to bondholders.
If the bond has been sold at face value, rather at a premium or discount, the entry made is very simple. The accounting entries made are a debit to Cash and a credit to Interest Income, both for the amount of the coupon payment. ABC Corporation decides to issue bonds to raise $100,000 for its business operations. These bonds have a 5-year maturity and a coupon rate (annual interest rate) of 4%, which is lower than the current market interest rate of 5% for similar risk bonds. Because of the lower coupon rate, investors require a discount to purchase these bonds, and the bonds are sold for $98,000.
Do You Debit or Credit Discounts on Bonds Payable?
The bond discount is also used in reference to the bond discount rate, which is the interest used to price bonds via present valuation calculations. 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). This means the bonds would have been paying any investors below the current market rate of interest. For an example of a bond discount, suppose that a company is preparing to issue some bonds that, at maturity, will be worth $20,000,000.
- For example, suppose your company issues a $1 million par value bond for $1.041 million that matures in 5 years.
- See Table 1 for interest expense calculated using the straight‐line method of amortization and carrying value calculations over the life of the bond.
- Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method.
- Bonds Payable is the promissory note which the company uses to raise funds from the investor.
We also need to mention here that the best fixed asset management software in 2021 account is a contra account, i.e. it has a natural balance opposite to the main account it relates to. So in our case, we are dealing with a liability for the bonds being issued, so the discount is a debit account. That means on the balance sheet, we will offset the discount account against the bond liability account, but more about that later on. The difference between the amount received and the face or maturity amount is recorded in the corporation’s general ledger contra liability account Discount on Bonds Payable. This amount will then be amortized to Bond Interest Expense over the life of the bonds.
Journal Entry for Discount on Bonds Payable
The discount of $3,851 is treated as an additional interest expense over the life of the bonds. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond). The bonds are issued when the prevailing market interest rate for such investments is 14%. Assume the investors pay $9,800,000 for the bonds having a face or maturity value of $10,000,000.
A contra account is an account that is offset against another account on the balance sheet. In the case of bonds payable, the discount is a contra account because it is subtracted from the face value of the bonds to arrive at the carrying amount or book value of the bonds. Likewise, we can make the journal entry for the amortization of bond discount by debiting the interest expense account and crediting the bond discount account. Even bonds are issued at a premium or discounted, we need to calculate the carrying value and compare with the cash payment to calculate the gain or lose. Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000.
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Journal entry for amortization of bond premium
Of course, we can use some tools to calculate the effective interest rate such as the excel spreadsheet where we can calculate the effective interest rate using the IRR() formula. In accounting, we may issue a bond at a discount or at a premium which results in the carrying value of the bonds payable recorded on the balance sheet being lower or higher than the face value of the bond. The issuer needs to recognize the financial liability when publishing bonds into the capital market and cash is received. The company has the obligation to pay interest and principal at the specific date. Bonds will be issued at par value when the coupon rate equal to market rate, there is no discount or premium on bond.
How do you record bonds that are issued?
The Discount on Bonds Payable serves as a way to adjust the actual cost of borrowing for the issuing company when bonds are sold at a discount, as it effectively increases the interest expense over the bond’s life. The debit entry brings the liability balance down to $0, while the credit entry reflects the payment at maturity to bondholders. Short-term bonds are often issued at a bond discount, especially if they are zero-coupon bonds. However, bonds on the secondary market may trade at a bond discount, which occurs when supply exceeds demand. The sum of the present value of coupon payments and principal is the market price of the bond.
Bonds issued at a Premium
However, when the bonds are actually sold to investors, the market interest rate is 6.1%. Since these bonds will be paying the investors less than the market rate of interest ($300,000 semiannually instead of $305,000), the investors will pay less than $10,000,000 for the bonds. In the same transaction, you debit interest expense for $40,900 and credit interest payable or cash for $45,000.
Straight-Line Amortization of Bond Discount on Monthly Financial Statements
The recorded amount of interest expense is based on the interest rate stated on the face of the bond. Any further impact on interest rates is handled separately through the amortization of any discounts or premiums on bonds payable, as discussed below. The entry for interest payments is a debit to interest expense and a credit to cash.
The amount recognized equates to the market rate of interest on the date when the bonds were sold. The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page.
