Amortizing Premiums and Discounts Financial Accounting

Rather than changing the bond’s stated interest rate to 8%, the corporation proceeds to issue the 9% bond on January 1, 2023. Since this 9% bond will be sold when the market interest rate is 8%, the corporation will receive more than the bond’s face value. Let’s examine the effect of a decrease in the market interest rates. First, let’s assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000. In this case, the corporation is offering a 12% interest rate, or a payment of $6,000 every six months, when other companies are offering an 11% interest rate, or a payment of $5,500 every six months.

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• The company has the obligation to pay interest and principal at the specific date.
• Bondholders do not become owners of a corporation like stockholders do.
• A corporation typically pays interest to bondholders semi-annually, which is twice per year.
• They are long- term liabilities for most of their life and only become current liabilities as of one year before their maturity date.
• As the timeline indicates, the corporation will pay its bondholders 10 semiannual interest payments of $4,500 ($100,000 x 9% x 6/12 of a year).
• Effective-interest techniques are introduced in a following section of this chapter.

Notice that interest expense is the same each year, even though the net book value of the bond (bond plus remaining premium) is declining each year due to amortization. For example, assume a company wants to issue a $1,000, 10% bond to the public when the market rate of interest is 12 percent. No one would, so the company drops the initial selling price lower than $1,000. This way the investors will actually make 12% on their investment. So the 50,000 in principle times the 9%, that’s the legal amount of interest that we owe to these people. And that’s going to be a yearly amount just like we discussed with face value bonds.

Summary of the Effect of Market Interest Rates on a Bond’s Issue Price

We have a rather good article (if we say so ourselves) covering the effective interest method in amortising certain balances. If you would like some more detail about the method, then please see our article here. This will increase the interest expense to make it equal to discount on bonds payable the effective rate of return to the bondholder. Bondholders receive only $6,000 every 6 months, whereas comparable investments yielding 14% are paying $7,000 every 6 months ($100,000 x .07). The above entry is made to showcase the settlement of Bonds Payable after the principal amount has subsequently been made. Before the settlement, Bonds Payable are represented as a Long Term Liability (Non-Current Liability) on the Balance Sheet.

• In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000.
• The company received cash of 105,154 which more than the bonds par value.
• As a result, your corporation’s semi-annual interest payments will be lower than what investors could receive elsewhere.
• However, due to the matching concept, this cost of $7,024 cannot be expensed when the bonds are issued but must be written off over the life of the bond.
• Another way to consider this problem is to note that the total borrowing cost is increased by the $7,722 discount, since more is to be repaid at maturity than was borrowed initially.
• Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances.

In order to attract investors, company needs to sell bond at $ 94,846 only. Bond issuers do this by creating a discount or lowering the selling price of the bond. When the market rate of interest is higher than the stated bond rate, the price of the bond must be lowered to equal the difference. And just like before, we already calculated that the discount is going to be amortized over the 10 periods, right? 10 total interest payments, that came out to $300 per period, right?

If a corporation redeems a bond prior to its maturity date, the carrying amount at the time should be compared to the amount of cash the issuing company must pay to call the bond. If the corporation pays more cash than what the bond is worth (the carrying amount), it experiences a loss. If it pays less cash than the bond’s carrying amount, there is a gain.

Bond Interest and Principal Payments

In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000. Let’s examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond’s stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000. Once a bond is issued the issuing corporation must pay to the bondholders the bond’s stated interest for the life of the bond.

Journal Entry for Discount on Bonds Payable

This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium. The difference between the 10 future payments of $4,500 each and the present value of $36,500 equals $8,500 ($45,000 minus $36,500). This $8,500 return on an investment of $36,500 gives the investor an 8% annual return compounded semiannually.

The Straight-Line Method

Essentially, the company incurs the additional interest, amounting to $7,024, at the time of issuance by receiving only $92,976 rather than $100,000.

Discount on Bonds Payable

This journal would be repeated every six months so that come June 30 in ten years, the discount account would have a $0 balance. It is reasonable that a bond promising to pay 9% interest will sell for more than its face value when the market is expecting to earn only 8% interest. In other words, the 9% bond will be paying $500 more semiannually than the bond market is expecting ($4,500 vs. $4,000). If investors will be receiving an additional $500 semiannually for 10 semiannual periods, they are willing to pay $4,100 more than the bond’s face amount of $100,000.