They did this because giving a discount but still
paying only 5% interest on the face value is mathematically the
same as receiving the face value but paying 7% interest. Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. The difference in the amount top 6 financial model best practices received and the amount owed is called the discount. Since they promised to pay 5% while similar bonds earn 7%, the company, accepted less cash up front. They did this because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value but paying 7% interest.

• The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%).
• When a corporation prepares to issue/sell a bond to investors, the corporation might anticipate that the appropriate interest rate will be 9%.
• Beyond FASB’s preferred method of interest
  amortization discussed here, there is another method, the
  straight-line method.

With two exceptions, bonds payable are
primarily the same under the two sets of standards. Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of accounting standards.

Accounting for Convertible Bonds

With corporate bonds, the periodic interest payments are considered taxable income to the investor. So the same investor receiving $1,000 of interest from a municipal bond would pay no income tax on the interest income. This tax-exempt status of municipal bonds allows the entity to attract investors and fund projects more easily. The discounted price is the total present value of total cash flow discounted at the market rate. The difference between cash receive and par value is recorded as discounted on bonds payable. The unamortized amount will be net off with bonds payable to present in the balance sheet.

• Before the bonds can be issued, the
  underwriters perform many time-consuming tasks, including setting
  the bond interest rate.
• The amount of the premium
  amortization is simply the difference between the interest expense
  and the cash payment.
• In order to attract investors, company needs to sell bond at $ 94,846 only.
• It becomes more complicated when the stated rate and the market rate differ.

In many situations, the interest rate agreed upon by both parties may not reflect the actual risk-reward relation. It means the market will ratify the difference whether the interest rate should be increased or decreased. Bonds also allow investors to earn a higher return on their investment while being less risky than other investments.

If issued on October 1, Year One, the creditors should pay for the bonds plus five months of accrued interest. Then, when Brisbane makes the first required interest payment on November 1 for six months, the net effect is interest for one month—the period since the date of issuance (six months minus five months). Many companies are not able to borrow money (or cannot borrow money without paying a steep rate of interest) unless some additional security is provided for the creditor. Any reduction of risk makes a note or bond instrument more appealing to potential lenders. For example, some loans (often dealing with the purchase of real estate) are mortgage agreements that provide the creditor with an interest in identified property.

Unit 15: Long-Term Liabilities and Investment in Bonds

As shown above, if the market rate is lower than the contract rate, the bonds will sell for more than their face value. Thus, if the market rate is 10% and the contract rate is 12%, the bonds will sell at a premium as the result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate is 14% and the contract rate is 12%, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate unless the price is reduced.

The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. When coupon rate is lower than market rate, company must calculate the market price of bonds. They will use the present value of future cash flow with market rate to calculate the bond selling price. In order to attract investors, company needs to sell bond at $ 94,846 only.

Journal Entry for Bond Issued at Discount

The financial liability will initially measure by using discounted cash flow of interest payment and bonds nominal value. Subsequently, we need to record the additional balance which arises from the difference between interest expense and interest paid. The interest expense depends on the effective interest rate while the interest paid to investors depend on the coupon rate. It is contra because it increases the
amount of the Bonds Payable liability account. The Premium will disappear over
time as it is amortized, but it will decrease the interest expense,
which we will see in subsequent journal entries.

Accounting For Bonds Payable

Other debts, serial debts, require serial payments where a portion of the face value is paid periodically over time. Part of each scheduled payment reduces the face value of the obligation so that no large amount remains to be paid on the maturity date. As mentioned above, as per the straight-line method, the amortization of bond premium is calculated by dividing the total interest on bonds by the total number of periods until the maturity date.

Accounting for bonds

When a bond is issued at a premium, the journal entry is a debit to the bonds payable account and a credit to the cash account for the face value of the bond, plus the premium. The premium is also recorded in an account called bond premium, which is a contra-liability account. In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31. The entries for 2022, including the entry to record the bond issuance, are shown next.

If the amount is material, or if a greater degree of accuracy is desired, calculate the periodic amortization using the effective interest method. This topic is inherently confusing, and the journal entries are actually clarifying. When a company issues bonds, they make a promise to pay interest
annually or sometimes more often. If the interest is paid annually,
the journal entry is made on the last day of the bond’s year. This example demonstrates the least complicated method of a bond issuance and retirement at maturity. There are other possibilities that can be much more complicated and beyond the scope of this course.

In other words, if the bonds are a long-term liability, both Bonds Payable and Premium on Bonds Payable will be reported on the balance sheet as long-term liabilities. The combination of these two accounts is known as the book value or carrying value of the bonds. On January 1, 2022 the book value of this bond is $104,100 ($100,000 credit balance in Bonds Payable + $4,100 credit balance in Premium on Bonds Payable). Thus, Schultz will repay $31,470 more than was borrowed ($140,000 – $108,530). All the amounts to be recorded over the four-year life of this bond can be computed to verify that the final payment does remove the debt precisely.

To record this action, the company would
debit Bonds Payable and credit Cash. Remember that the bond payable
retirement debit entry will always be the face amount of the bonds
since, when the bond matures, any discount or premium will have
been completely amortized. When performing these calculations, the rate is adjusted for
more frequent interest payments.