Notice how similar this is to the journal entry we just made above, except instead of cash, we have interest payable, $2,550 right there, okay? So our interest payable, this is a liability in this case, right? Interest payable because we’re going to pay it off tomorrow and that’s increasing our liabilities. The same thing with the discount, as we get rid of this discount balance, it’s going to keep increasing our liabilities up to that par value for the bonds. And the interest expense, well that’s decreasing our equity because this is an expense on our income statement and that’s decreasing our equity by $2,550, so everything stays balanced here.
The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period. This means that as a bond’s book value increases, the amount of interest expense will increase. 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.
Bonds Payable Issued at Discount Journal Entry
In other words, under the accrual basis of accounting, this bond will require the issuing corporation to report Interest Expense of $9,000 ($100,000 x 9%) per year. While the issuing corporation is incurring interest expense of $24.66 per day on the 9% $100,000 bond, the bondholders will be earning interest revenue of $24.66 per day. With bondholders buying and selling their bond investments on any given day, there needs to be a mechanism to compensate each bondholder for the interest earned during the days a bond was held. The accepted technique is for the buyer of a bond to pay the seller of the bond the amount of interest that has accrued as of the date of the sale.
- As a result, bond investors will demand to earn higher interest rates.
- The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method.
- Bonds allow an entity to borrow large sums at low-interest rates.
- Before this interest expense because the discount was sitting at 3,000.
- The unamortized amount will be net off with bonds payable to present in the balance sheet.
Let’s illustrate this scenario with a corporation preparing to issue a 9% $100,000 bond dated January 1, 2024. The bond will mature in 5 years and requires interest payments on June 30 and December 31 of each year until December 31, 2028. The bond is issued on February 1 at its par value plus accrued interest.
To a business, a bond payable represents a series of regular interest payments together with a final principal repayment at the maturity date. To an investor, the bond is a series of interest receipts followed by the return of the principal at the maturity date. The interest is determined by the bond principal and the bond interest rate known as the bond coupon rate. Bonds payable are long term liabilities and represent amounts owed by a business to a third party.
Example of the Amortization of a Bond Discount
Note that in 2024 the corporation’s entries included 11 monthly adjusting entries to accrue $750 of interest expense plus the June 30 and December 31 entries to record the semiannual interest payments. The premium and discount accounts are viewed as valuation accounts. The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable. The entry to record the issuance of the bonds increases cash for the $11,246 received, increases bonds payable for the $10,000 maturity amount, and increases premium on bonds payable for $1,246.
Timeline for Interest and Principal Payments
- So we had that debit balance of 3,000 and we’re going to be amortizing it over the 10 interest payments, 5 years twice per year.
- Well, now there’s less discount, so our liabilities have increased from 47,000 to 47,300.
- Throughout our explanation of bonds payable we will use the term stated interest rate or stated rate.
- 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.
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet reports information as of a date (a point in time). Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
Accounting For Bonds Payable
Issuing bonds rather than entering into a loan agreement can be attractive to organizations for many reasons. Bonds allow an entity to borrow large sums at low-interest rates. They also give organizations greater freedom as bank loans can often be more restrictive. Additionally, the interest payments made for some bonds can also be used to reduce the amount of corporate taxes owed. Even with these benefits considered, governments and municipalities issue bonds more often than public or private organizations. The carrying value of a bond is not equal to the bond payable amount unless the bond was issued at par.
Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant. The difference between the present value of $67,600 and the single future principal payment of $100,000 is $32,400. This $32,400 return on an investment of $67,600 gives the investor an 8% annual return compounded semiannually. The remaining columns of the PV of 1 Table are headed by interest rates. The interest rate represents the market interest rate for the period of time represented by “n“.
Usually a bond’s stated interest rate is fixed or locked-in for the life of the bond. Assume the investors pay $9,800,000 for the bonds having a face or maturity value of $10,000,000. The difference of $200,000 will be recorded by the issuing corporation as a debit to Discount on Bonds Payable, a debit to Cash for $9,800,000, and a credit to Bonds Payable for $10,000,000. 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. The balance of premium on bonds payable will be included in bonds payable.
Market Interest Rates and Bond Prices
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. The company may decide to buyback bonds before the maturity date. 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.
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 factors contained in the PVOA Table represent the present value of a series or stream of $1 amounts occurring at the end of every period for “n” periods discounted by the market interest rate per period. We will refer to the market interest rates at the top of each column as “i“.
The second component of a bond’s present value is the present value of the principal payment occurring on the bond’s maturity date. The principal payment is also referred to as the bond’s maturity value or face value. The difference between the 10 discount on bonds payable on balance sheet 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.
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? So, it’s the same calculations we did in the last video, they carry on here. That’s why the straight line method is so easy because we’re just going to be doing $300 per period of this discount amortization.
On maturity, due to amortization of premium/discount, the carrying value will become same as face value on the debt instrument. One of the main financial statements (along with the statement of comprehensive income, balance sheet, statement of cash flows, and statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations.
By the time the bond is offered to investors on January 1, 2024 the market interest rate has increased to 10%. The date of the bond is January 1, 2024 and it matures on December 31, 2028. The bond will pay interest of $4,500 (9% x $100,000 x 6/12 of a year) on each June 30 and December 31. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.
Both of these statements are true, regardless of whether issuance was at a premium, discount, or at par. On July 1, 2019, ABC Corporation issued bonds worth $10,000 for a ten-year period with a coupon rate of 10% and semi-annual payments. The format of the journal entry for amortization of the bond discount is the same under either method of amortization – only the amounts recorded in each period will change. Journal entries usually dated the last day of the accounting period to bring the balance sheet and income statement up to date on the accrual basis of accounting. Usually financial statements refer to the balance sheet, income statement, statement of comprehensive income, statement of cash flows, and statement of stockholders’ equity. Some bonds require the issuing corporation to deposit money into an account that is restricted for the payment of the bonds’ maturity amount.