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Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.
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. When a bond is issued at a price below its face value, it means investors are willing to accept a lower interest rate (coupon rate) than the prevailing market rates. The discount on bonds payable represents the unamortized portion of that initial difference between the face value and the issue price.
The income statement for all of 20X3 would include $6,294 of interest expense ($3,147 X 2). 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. A bond issuer benefits from issuing a bond at a discount because they are able to raise money at a lower cost. 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).
If the amount received is less than the par value, the difference is known as the discount on bonds payable. If there was a discount on bonds payable, then the periodic entry is a debit to interest expense and a credit to discount on bonds payable; this has the effect of increasing the overall interest expense recorded by the issuer. The first short-lived attempt at issuing banknotes by a central bank was in 1661 by Stockholms Banco, a predecessor of Sweden’s central bank Sveriges Riksbank. This banknote issue was brought about by the peculiar circumstances of the Swedish coin supply.The interest rate that determines the payment is called the coupon rate.
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). 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). To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. The periodic interest is an annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the tenth period. The 8% market rate of interest equates to a semiannual rate of 4%, the 6% market rate scenario equates to a 3% semiannual rate, and the 10% rate is 5% per semiannual period. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis.
The premium or discount is to be amortized to interest expense over the life of the bonds. It is worth remembering that the $6,000 annuity, which is the cash interest payment, is calculated on the actual semi-annual coupon rate of 6%. The Discount on Bonds Payable account is a contra-liability account in that it is offset against the Bonds Payable account on the balance sheet in order to arrive at the bonds’ net carrying value. Understanding how to record and manage Discounts on Bonds Payable is vital for companies and organizations that issue bonds as a means of raising capital.
As the discount is amortized, the discount on bonds payable account’s balance decreases and the carrying value of the bond increases. The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account. As with the straight‐line method of amortization, at the maturity of the bonds, the discount account’s balance will be zero and the bond’s carrying value will be the same as its principal amount. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization . When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable.
Treasury notes, commonly referred to as T-notes, are financial securities that generally have longer terms than Treasury bills, but shorter terms than Treasury bonds. T-notes are issued by the U.S. government when it aims to generate funds to pay down debts, what is certified payroll undertake new projects, or improve infrastructure, for the benefit of the nation and the overall economy. The notes, which are sold in $100 increments, pay interest in six-month intervals and pay investors the full face value of the note, upon maturity.
Note that Valley does not need any interest adjusting entries because the interest payment date falls on the last day of the accounting period. The income statement for each of the 10 years would show Bond Interest Expense of $12,000 ($ 6,000 x 2 payments per year); the balance sheet at the end of each of the years 1 to 8 would report bonds payable of $100,000 in long-term liabilities. At the end of ninth year, Valley would reclassify the bonds as a current liability because they will be paid within the next year. One simple way to understand bonds issued at a premium is to view the accounting relative to counting money!
Reducing this account balance in a logical manner is known as amortizing or amortization. Since a bond’s discount is caused by the difference between a bond’s stated interest rate and the market interest rate, the journal entry for amortizing the discount will involve the account Interest Expense. 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.
They will use the present value of future cash flow with market rate to calculate the bond selling price. Bonds Issue at discounted means that company sell bonds at a price which lower than par value. Due to the market rate and coupon rate, company may issue the bonds with discount to the investor. Company will discount to attract investors when the coupon rate is lower than the market rate. The investors paid only $900,000 for these bonds in order to earn a higher effective interest rate.
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.
Issuers usually quote bond prices as percentages of face value—100 means 100% of face value, 97 means a discounted price of 97%of face value, and 103 means a premium price of 103% of face value. For example, one hundred $1,000 face value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value (or principal amount) of the bonds. Next, let’s assume that just prior to offering the bond to investors on January 1, the market interest rate for this bond increases to 10%. The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate. Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount.