What is a Discount on Bonds Payable? Definition Meaning Example

Here is a comparison of the 10 interest payments if a company’s contract rate is more than the market rate. The carrying amount can be thought of as “what the bond is worth” at a given point in time. Initially, the carrying amount is the amount of cash received when the bond is issued. Here is a comparison of the 10 interest payments if a company’s contract rate is less than the market rate. Thus, Schultz will repay $31,470 more than was borrowed ($140,000 – $108,530). Short-term bonds are often issued at a bond discount, especially if they are zero-coupon bonds.

  • Compare the contract rate with the market rate since this will impact the selling price of the bond when it is issued.
  • The investors want to earn a higher effective interest rate on these bonds, so they only pay $950,000 for the bonds.
  • When a bond is issued at a premium, the carrying value is higher than the face value of the bond.
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A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest.

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Firms report bonds to be selling at a stated price “plus accrued interest”. The issuer must pay holders of the bonds a full six months’ interest at each interest date. Thus, Schultz will repay $47,722 ($140,000 – $92,278) more than was borrowed. Spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20 (not to be confused with the periodic cash payment of $4,000). Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.

The maturity date is the date that the corporation must pay back the full face amount to the bondholders. Another possibility is for the corporation to issue bonds, which are also a form of debt. Bonds are loans made by smaller lenders, such as other corporations and individual people. A corporation may borrow from many different smaller investors and collectively raise the amount of cash it needs.

Where is the premium or discount on bonds payable presented on the balance sheet?

Thus, the bonds sell at a yield to maturity of 8%, resulting in a premium. Company C issue 9%, 3 years bond when the market rate is only 8%, par value is $ 100,000. When the coupon rate is higher than effective interest rate, the company can sell bonds at a higher price.

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The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. A bond issued at a discount has its market price below the face value, creating a capital appreciation upon maturity since the higher face value is paid when the bond matures. The bond discount is the difference by which a bond’s market price is lower than its face value.

Is it better to buy a bond at a discount or premium?

There are times when the contract rate that your corporation will pay is less than the market rate that other corporations will pay. As a result, your corporation’s semi-annual interest payments will be lower than what investors could receive elsewhere. To be competitive and still attract investors, the bond must be issued at a discount. This means the corporation receives less cash than the face amount of the bond when it issues the bond. The corporation still pays the full face amount back to the bondholders on the maturity date. The interest expense is calculated by taking the Carrying Value ($100,000) multiplied by the market interest rate (5%).

The reason bondholders lend their money is because they are paid interest by the corporation on the amount they lend throughout the term of the bond. Accountants have devised a more precise approach to account for bond issues called the effective-interest method. Be aware that the more theoretically correct effective-interest method is actually the required method, except in those cases where the straight-line results do not differ materially. Effective-interest techniques are introduced in a following section of this chapter. The following table summarizes the effect of the change in the market interest rate on an existing $100,000 bond with a stated interest rate of 9% and maturing in 5 years.

This method of accounting for bonds is known as the straight-line amortization method, as interest expense is recognized uniformly over the life of the bond. 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. The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the premium or discount account is the unamortized balance. For example, a bond with a par value of $1,000 that is trading at $980 has a bond discount of $20. 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.

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