What is a Discount on Bonds Payable? Definition Meaning Example

This process continues until the bond reaches maturity, at which point the Discount on the Bonds Payable account is reduced to zero, and the carrying value matches the face value of the bond. Thus, Schultz will repay $31,470 more than was borrowed ($140,000 – $108,530). This $31,470 must be expensed over the life of the bond; uniformly spreading the $31,470 over 10 six-month periods produces periodic interest expense of $3,147 (not to be confused with the actual periodic cash payment of $4,000). A contra account is an account that is offset against another account on the balance sheet.

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. When a bond is issued at a premium, the carrying value is higher than the face value of the bond.

This illustrates how companies strategically use bond discounts to balance immediate capital needs with long-term financial considerations. One simple way to understand bonds issued at a premium is to view the accounting relative to counting money! If Schultz issues 100 of the 8%, 5-year bonds when the market rate of interest is only 6%, then the cash received is $108,530 (see the previous calculations).

On issuance, a premium bond will create a “premium on bonds payable” balance. The actual interest paid out (also known as the coupon) will be higher than the expense. In this example, the discount allowed ABC to attract investors, but the company will face higher interest expenses as it repays the bonds at their full face value. Investors, on the other hand, have the opportunity for potentially higher returns due to the discounted purchase price.

By the time the bond matures, the interest expense equals the cash interest payment, and the Discount on the Bonds Payable account is reduced to zero. The investors paid only $900,000 for these bonds in order to earn a higher effective interest rate. Company A recorded the bond sale in its accounting records by increasing Cash in Bank (debit asset), Bonds Payable (credit liability) and the Discount on Bonds Payable (debit contra-liability).

discount on bonds payable definition

Schultz will have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). However, the accounting treatment of bonds issued at a discount involves the gradual recognition of this discount as an additional interest cost over the life of the bond. While this results in lower initial interest expenses for the company, it leads to an increase over time as the discount is amortized. Investors, in turn, recognize the potential for capital gains as the bonds approach maturity and are repaid at their face value. Initially, the interest expense is lower than the cash interest paid because the company is amortizing the discount. As time progresses, the amortization decreases, causing the interest expense to rise.

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. Airlines often resort to bond issuances for financing, and in 2020, United Airlines issued $3.8 billion in bonds at a discount. The aviation industry faced severe financial challenges due to the COVID-19 pandemic, and the discount on bonds was a reflection of the market’s skepticism about the industry’s recovery.

ABC Corporation, a tech company, issued bonds at a discount to raise funds for a new project. However, due to uncertainties in the market, investors were hesitant, https://www.bookkeeping-reviews.com/see-top-10-analytics-business-intelligence-trends/ and ABC had to offer the bonds at a discounted price of $950 each. An analyst or accountant can also create an amortization schedule for the bonds payable.

Financial Outcome:

The discount represents the difference between the face value of the bonds and the proceeds received from their sale. The decision to issue bonds at a discount is a delicate balance for companies, considering the trade-off between immediate capital needs and the long-term financial implications. The discount on bonds payable reflects not only the financial intricacies of the issuing entity but also the dynamics of the market in which the bonds are offered. Overall, the use of bond discounts showcases the financial creativity and strategic thinking companies employ to navigate the complexities of the capital market while meeting their funding requirements. In conclusion, the issuance of bonds at a discount is a financial strategy employed by companies to raise capital, often in circumstances where market conditions or perceived risks may deter investors.

1. If prevailing interest rates in the market are higher than the coupon rate offered by the bonds, investors may be unwilling to pay the full face value.
2. Depending on the current market, investors might be unwilling to earn the interest rates that the bond states.
3. If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10%), Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity).
4. As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) that was implicit in the pricing of the bonds.
5. The electric vehicle company offered $1.38 billion in convertible senior notes, which could be converted into Tesla common stock.
6. Airlines often resort to bond issuances for financing, and in 2020, United Airlines issued $3.8 billion in bonds at a discount.

If prevailing interest rates in the market are higher than the coupon rate offered by the bonds, investors may be unwilling to pay the full face value. In such cases, companies may issue bonds at a discount to attract investors financial vs managerial accounting with the promise of higher effective yields. To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. Because the bonds have a 5-year life, there are 10 interest payments (or periods).

What are Bonds Payable?

This practice provides an immediate influx of funds for the issuing company, allowing them to undertake projects, address financial challenges, or seize investment opportunities. Investors, enticed by the discounted purchase price, may see these bonds as an opportunity for potentially higher yields compared to bonds issued at face value. They are essentially IOUs issued by companies, municipalities, or governments to raise capital. When an entity issues bonds, it is borrowing money from investors in exchange for periodic interest payments and the promise to repay the principal amount at a specified future date, known as the maturity date. If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10%), Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity).

Another way to illustrate this problem is to note that total borrowing cost is reduced by the $8,530 premium, since less is to be repaid at maturity than was borrowed up front. Therefore, the $4,000 periodic interest payment is reduced by $853 of premium amortization each period ($8,530 premium amortized on a straight-line basis over the 10 periods), also producing the periodic interest expense of $3,147 ($4,000 – $853). If a bond is issued at a premium or at a discount, the amount will be amortized over the years through to its maturity.

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Each yearly income statement would include $9,544.40 of interest expense ($4,772.20 X 2). The straight-line approach suffers from the same limitations discussed earlier, and is acceptable only if the results are not materially different from those resulting with the effective-interest technique.