Discount on Bonds - Online Tutor, Practice Problems & Exam Prep

Issuing Bonds at a Discount

All right. Now, let's move on to Discounted Bonds. And after you're done with this lesson, I want you guys to compare the discounted bonds with the premium bonds that we're going to be studying in the next lesson and see how they're basically the exact opposite of each other, alright? So let's start here with discounted bonds and then we'll do premium bonds in the next lesson. So a bond is issued at a discount when the stated rate is, do you guys remember? Compared to the market rate. Well, the stated rate, let's say, is 8%. We're in a situation where we're saying, "Hey, we're offering 8% interest and the market is offering 10% interest." Well, in this case, we are going to issue a discount, right? Because the stated rate is less than the market rate. So the market people would rather buy the bonds on the market, right? They're offering more interest, so they would rather buy those bonds as investments rather than our bonds. So our bonds are going to have to sell at a discount to be able to sell them at all. Okay? So let's go on here to our gray box, and let's discuss these stated rates versus the market rate. Right? So we have already discussed the situation where we have a stated rate equal to the market rate. So that will be a situation where they're both equal to 10%. We're offering 10% on our bonds. The market is offering 10% on the bonds. Well, these bonds will be sold equal to the face value, right? And these were called the face value bonds or par value bonds. Par value as well. Okay? Now, we're moving on to a situation where the stated rate, let's say, would be, maybe, 8%, while the market is offering 10%. And these could be any number, right? They could be 5% and 6%, 9% and 12%. As long as the market rate is greater than the stated rate, well, we're going to be in this situation where the market is offering better bonds than what we're offering. So the price of bonds is going to be less than the face value. And that's the situation we're going to discuss in this video: these discounted bonds. Okay? So we're focused on discounted bonds in this video. Let me put a little star right here because that's what we're focused on. Next, we have the opposite. A situation where we're offering 12%, let's say, when the market is offering 10%. Now our bonds are more enticing to investors and they'd rather buy our bonds than the market. So they're going to sell at a price greater than the face value. And that's a situation where we're selling at a premium, okay? So remember, in all these situations, we're talking about bonds payable. This is a liability to the company. We're getting cash now and that's what's going to be this price of the bond today. We're going to get cash now and then we're going to have to repay it later. So we're going to pay interest over the life of the bond and then finally, the principal repayment at the end. Okay? So let's look at the issuance journal entry for a discounted bond. On January 1, 2018, ABC Company issues $50,000 of 9% bonds. So remember, $50,000, this is the principal amount, this is the face value. So this is the amount that we use when we calculate our cash interest. The $50,000 with the stated rate right here of 9%. And it tells us that the bonds mature in 5 years, that's the maturity date will be 5 years from now. Interest is payable semi-annually. So remember, when you see the semi-annual, that's 2 interest payments per year on January 1st and July 1st. The market interest rate was equal to 10%. So notice, in this case, we've got a difference. The stated rate is 9%, the market rate is 10%. And usually, when you do it in this class, they're going to tell you something like this, the bonds were issued at 94, okay? Were issued at 94 and what did we say that this 94 meant? It's a percentage of the face value, right? The amount of cash we received was a percentage of the face value. And it makes sense that it's less than 100%, right? We're only receiving 94% of the face value because let's look at those interest rates. Our stated rate is only 9%. We're saying, "Hey, come buy our bonds. We're giving 9% interest." While the rest of the market is saying, "Hey, come buy our bonds. We're offering 10% interest." People would rather buy the market bonds than our bonds. So we have to offer them at a discount. So let's go ahead and calculate that discount cash that we're going to receive. So the cash received is not going to be $50,000 in this case. Let me clean that up. The cash received is going to be the $50,000 in face value times 94% 0.94. So that's going to equal $50,000 times 0.94. Let's go ahead and put that in our calculator. That comes out to $47,000, right? So notice, we're not receiving the full $50,000 anymore. We're receiving less than that. And why? That's because we're offering less interest. People would rather buy the other bonds for $50,000; they would pay $50,000 for the other bonds because they're offering the market rate. But our bonds are offering less than the market rate, so they're going to be willing to pay us less for them. In this case, we will only be able to raise $47,000. But make a note that when we have to pay these bonds off at maturity, in 5 years from now, we don't repay them $47,000, we repay them $50,000. We repay the principal amount. The full face value of $50,000 is what we're going to repay in 5 years. But we only received $47,000 in cash today because of the lower interest rate. Okay? So let's see how that affects our journal entry. We know we're going to debit cash because we're receiving cash and we just calculated that that's going to be $47,000, right? $47,000 in cash, that's going to be our debit. Now, we also know that we have a bond payable, right? We have this liability now and we're going to be paying off $50,000. Just like I said in our previous lesson on face value bonds, the bonds payable account will always be the face value amount, okay? So the face value of the bonds was $50,000, that has to be what we put into the bonds payable liability. But notice that our equation doesn't balance here, right? Our debits are $47,000. Our credits are $50,000. We need more debits. In this case, we need debits of $3,000 to balance this out. And this account, what we're going to use is called discount on bonds payable, okay? So this is an additional debit account here. And this is a contra account to the bonds payable account, okay? So remember we talked about those contra accounts? Well, it's going to be related to the bonds payable account. In this case, it's a debit balance. So let's think about what happens here. We had this credit of $50,000 to the bonds payable. Well, we have this related debit of $3,000. And what this does is it brings the carrying value of the bond, the book value. So when we show our balance sheet, the balance sheet is going to show, "Hey, we have bonds payable of $50,000 less a discount of $3,000." So the carrying value of the bond on the liabilities is going to show $47,000. Okay? And over the life of the bond, we're going to be amortizing that discount and it's going to be shrinking until we get to maturity. So we'll see how we deal with that in the interest expense entries coming up. But for now, this is very important. This is how we set up our issuance of a discount bond, okay? So we always put the full face value of bonds payable, the full payable, the full $50,000 and then the cash amount and the difference between the two. Well, that's going to be the discount or the premium once we get to premiums, okay? In this case, we have a discount because we've got less cash than the face value. So let's go ahead and set this up. Our cash increased by $47,000, right? We had an increase of cash of $47,000 and then we had an increase in bonds payable of $50,000, but it would be less the discount of $3,000, right? We had this debit of $3,000 and that comes out to a $47,000 increase in let me clean that up. That comes out to a $47,000 increase in our liabilities there as well. $47,000 increase, right? So our cash went up by $47,000 and our liabilities went up by $47,000. Notice the bonds payable account has that full face value because that's the amount that we will pay off at maturity. Alright?

Discount Bonds:Interest Expense, Amortization, and Cash

All right. So now let's see how we're going to do interest expense. As we go through these first examples, I'm going to be using the straight line method of amortization. Okay? And when I say amortization, we're going to be amortizing that discount. We had a discount of $3,000 and we're going to amortize it over the life of the bond into interest expense, okay? I'm going to show you what that means in a second, but I want to make a note to you. The straight line method is not technically GAAP. It is not GAAP. But in this class, it's very easy and they generally use it because most of the time it's not so different from the GAAP method. Now if your teacher is really enthusiastic and really wants to teach you the more difficult method, we're going to have a video on that method as well. Just make sure whether your teacher is going to focus on straight line, effective interest method, or both. Okay? You might even need to know both. But for now, let's focus on the straight line method, just so you can kind of see how this works. And a lot of the principles between straight line and effective are very similar. Okay? So let's go ahead and dive into this interest expense entry. And through interest expense is where that discount will disappear, okay? So let's go ahead and see how this works.

On January 1, 2018, ABC Company issues 50,000 of 9% bonds maturing in 5 years. Interest is payable semiannually on January 1 and July 1, the market interest rate was equal to 10%, the bonds were issued at 94. So remember that we had that $3,000 with the $3,000 in the discount, right? So now that we're focused on the straight line amortization method, we're going to amortize it using the straight line method over the amount of interest payments we're going to make. So if you think about it, this is a 5 year bond, right? This bond is maturing in 5 years, but we're paying interest twice a year. So there's going to be 10 total interest payments. So each interest payment, we're going to amortize some of this discount. Okay? So we're going to take that 3,000 discount and divide it by 10, and that means that we're going to amortize 300 per period, amortized. Okay?

And we're going to see what this what I keep saying amortize. What does that mean? Well, that means we're taking that 3,000 that's sitting in the discount account and we're going to get rid of it. Over the life of the bond, we don't want it there anymore. Because remember, at maturity, we're going to pay the full 50,000, not the 47,000 that's currently on our books. So we need to increase the value of this liability up to the 50,000 from the 47,000 it's at right now. We need to keep increasing it over the life of the bond until it's worth 50,000 at maturity. All right? So let's see how that works in this journal entry. We're going to be amortizing 300 per period of our discount, but we're also going to be paying cash, right? Just like before, we had our cash interest payments where we had 50,000 in principal times the stated rate, right? We're the cash interest that we pay is based on the stated rate. It doesn't matter the market rate. We're saying, hey, we're paying 9%. Well, we're going to pay 9%

So the 50,000 in principle times the 9%, that's the legal amount of interest that we owe to these people. And that's going to be a yearly amount just like we discussed with face value bonds. So we have to divide it by 2 because we're dealing with this semiannual interest. So the 9% is an annual interest amount, so we divide it by 2 because we pay interest twice per year, so each interest payment is going to be half of the annual amount. So 50,000 times 0.09 divided by 2, times 0.09 divided by 2 comes out to 2,250 and this is the cash interest that will be paid.

Now, I want to make a note between this and the face value bonds. In the face value bonds, the cash interest was our interest expense. That's not the case anymore. Unfortunately, when we've got a discount or a premium, our interest expense is going to be different from the actual cash interest that we paid, and that's because we're amortizing the discount or the premium. So let's go ahead and see how we're going to amortize this discount. We know that we're going to have a credit to cash on July 1, when we have this 6 months of interest we're paying, well, we're going to pay off 2,250 in cash. Right? So that's going to be one of our credits. But notice, we also had this discount. And the discount had a debit balance, right? Because we had a credit to bonds payable and then the discount which was lowering the value of bonds payable down to 47,000, we had that $3,000 value. Well, we want to get rid of that discount. And since it had a debit balance before, we get rid of it with credits. And what that's going to be doing is going to be increasing the value of the bond as we keep crediting to these liabilities. Okay? So let's go ahead and see what we do here. We're going to credit discount on bonds payable, and I'm going to put discount on BP for bonds payable. So we're going to be crediting the discount account because remember, up here, when we first issued the bonds, it had a debit balance, right? We issued them with a debit balance in the previous video and now we're going to be crediting it to get rid of that debit balance. 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. We're going to be amortizing it 300 per period, so we're going to have a credit of 300. So what does that do to our discount account? Our discount is now 3,000 debit, right? Well, let me do it as a T account, right? We have the T account for discount on bonds payable and it had a debit balance of 3,000 in the first entry. Well, right now, we're crediting it for 300. So that's going to bring its value down to 2,700 as a debit balance, right? So now the debit balance is only 2,700 rather than 3,000, okay? So what does that mean? The bonds, we still have bonds payable. So when we show our balance sheet, we're still going to show bonds payable of 50,000, but now it's going to be less discount instead of 3,000, the discounts only going to be 2,700. So our bond instead of being 47,000 is now 47,300. So our liability increases, right, because of this credit to discount on bonds payable and it's going to keep increasing over the life of the bond. Okay? So So that's what that credit to bonds payable does or credit to discount on bonds payable does. It's increasing that carrying value on the balance sheet of our bonds payable. Okay? So the last part of this entry, well, guess what? This is an interest expense entry, right? We're paying interest, so we're going to have interest expense here. And that's going to be our debit. So our debit to interest expense, well, it's going to be the sum of these 2. We paid the cash and we're going to amortize some of the discount of 300. So this comes out to 2,550. Alright? And this is about as tricky as this class gets. Okay? So if you understood this, wow. I'm really proud of you for getting this on the first try. But I don't expect you to really understand everything we went through, okay? So we're going to keep going through this example and then you're going to see it with premiums on bonds payable. And I hope once you see both of them side by side, this will start to make a lot more sense. And then I want you guys to to keep hammering this in because this is about as tough as this course is going to get. Okay? So this is our journal entry right here. We're going to debit interest expense 2,550, credit the discount on bonds payable to lower its value a bit, and we're going to credit cash for the actual cash that we paid out. Okay? So what happened in this entry? Well, our cash decreased by 2,250, but what else happened? We had our discount on bonds payable, Remember, it had a debit balance and we credited it. So it has less of a debit balance. So it increased our liabilities, right? Just like we saw here. Before, we had a net balance of 47,000, right? Before this interest expense because the discount was sitting at 3,000. Well, now there's less discount, so our liabilities have increased from 47,000 to 47,300. So that's an increase to our liabilities of 300 and then our interest expense, well that's a decrease to equity, right? 2,550 decrease to equity. So the decrease to equity 2,550, the increase to liabilities of 300, that equals the decrease to assets of 2,250. This is getting a little bit complicated, right? Now let's keep it going in the next video.

Discount Bonds:Interest Expense, Amortization, and Interest Payable

All right, so just like we had in the face value bonds, we're going to be creating an interest payable in this entry, right? Because now we've reached December 31, 2018, and it's time to release our financial statements. We want to show our balance sheet, we want to show our income statement, and we're going to do that as of December 31, 2018. So, we need to account for those 6 more months of interest this year. Just like before, we're going to have the same cash interest, and we're going to calculate it in the same way. The $50,000 times the 9% that the bonds say that they pay, and we divide by 2 because it's semi-annual periods, and that's going to give us the same cash interest of $2,250, right?

And just like before, we already calculated that the discount is going to be amortized over the 10 periods, right? We have the $3,000 discount divided by the 10 payment periods. We have 5 years with 2 payment periods each year. 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. Okay? So, we have the cash, we have the discount.

Now, the only difference is that actually, when I say cash, we're not paying it in cash on December 31st, right? We're going to be paying it on January 1st the following year. So, this is technically our interest payable that we have as of December 31st is the $2,250. Our journal entry is going to look very similar, except instead of cash, we're going to have interest payable in this one. So, we know that we're going to be paying interest tomorrow on January 1st. We're going to be paying interest of $2,250. So, we have this liability to pay $2,250, for the 6 months that have passed. We're also going to credit the discount again. The discount on bonds payable is going to keep decreasing here, right? Another $300, being decreased.

And let's look at that T account over here for the discount. So remember, it started with a $3,000 balance and then we took $300 out in our first interest payment, now another $300. Now we're sitting at a $2,400 debit balance, right? And just like we saw before, that's going to keep increasing the value of the liability, right? The bonds payable, the carrying amount on our balance sheet, it's going to keep increasing up to that $50,000 par value that we're going to end up paying off on the maturity date. Okay? So these are our credits. We have our interest payable that we're going to pay off tomorrow and then we have the discount that we have to amortize over the 10 periods.

And finally, we have interest expense. 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. This entry is not very different from the previous entry we made. The main difference here is that we have interest payable because we haven't paid it yet till January 1st.

Obviously, on January 1st, 2019, so the next day, we're going to make an entry to debit interest payable and credit cash, right? Because we're actually going to make that payment and that's going to be in the amount of $2,250, getting rid of the liability for interest payable. Okay? So that's about it for this entry. Very similar to the entry we made on the previous page. Let's go ahead and see what happens when we repay the principal.

Discount Bonds:Repaying Principal at Maturity

All right. So now we finally reach the maturity date. We're going to be making those journal entries just like we did for interest expense over the life of the bond. We're going to keep making those same journal entries every year. So if you can think about it, our discount on bonds payable, if we look at the discount on bonds payable, remember, it's been 10 periods that have passed now. We finally reached the maturity date. So we started at $3,000 as a debit balance, and we kept making $300 credits to the account with every interest payment. And we did that 10 times. 300 times 10, well that's $3,000, right? So, we've reached the point where there's no balance left in the discount on bonds payable. All of the discount has been amortized to interest expense over the 5 years, right? Because we would have kept making those same interest expense journal entries and amortizing $300, $300, $300, 10 times over the 10 interest payments. Okay? So there's no more discount on bonds payable. All that's left is our liability of bonds payable of $50,000. So now once we've reached the maturity date, it makes sense. Our balance sheet shows, hey, you owe $50,000 and that's exactly what we owe right now, right? The $50,000 that we're going to pay off because the discount is gone. Remember when I was showing you before, we were showing bonds payable that always has the entire principal value in it, 50,000 and we had less discount. Well, guess what? After we've gotten rid of the discount, there's no discount left at this point</p><p>We've amortized it to interest expense over the life of the bond. So our bonds payable is showing a value of $50,000 and that's what we're going to pay off right now. We're gonna debit bonds payable for $50,000 on the maturity date and that gets rid of the liability, right? We had a credit balance of $50,000 and now we're debiting it $50,000. It's gone. And how do we get rid of it? By paying off the principal in cash for $50,000. So now we've paid off the full $50,000 principal in cash. Remember, even though we raised $47,000 when we issued the bonds, we still have to pay the full $50,000 upon maturity. Okay? That's the big deal here. You pay off the face value of the bonds regardless of the amount of money that you raised initially. Cool? Alright. So in this case, our cash has decreased by $50,000 and our liabilities decreased by $50,000 as well. Alright. So this stays balanced and we're good here. This is always the easiest journal entry because all we got to do is get rid of the face value that's sitting on our books, and we get rid of the cash. That's how we paid for it. Cool? Let's go ahead and do a practice problem before we move on to premium on bonds payable.

In 2014, ABC Company issued $100,000, 10%, bonds while the market interest rate was 12%. The bonds mature in the current year. The amount of principal that ABC Company will repay in the current year is equal to:

• A. $0
• B. An amount greater than $0 but less than $100,000
• C. $100,000
• D. Some amount greater than $100,000

Here’s what students ask on this topic:

What is a discount on bonds payable?

A discount on bonds payable occurs when bonds are issued for less than their face value. This happens when the stated interest rate on the bond is lower than the prevailing market interest rate. For example, if a bond has a face value of $50,000 with a stated interest rate of 9%, but the market rate is 10%, the bond will sell at a discount. The discount represents the difference between the bond's face value and its selling price. This discount is amortized over the life of the bond, increasing the bond's carrying value until it reaches its face value at maturity.

How do you calculate the cash received from issuing a discounted bond?

The cash received from issuing a discounted bond is calculated by multiplying the bond's face value by the issuance percentage. For example, if a bond with a face value of $50,000 is issued at 94%, the cash received would be:

$\mathrm{50,000}\times 0.94=\mathrm{47,000}$

This means the issuer receives $47,000 in cash, even though the bond's face value is $50,000. The $3,000 difference is the discount, which will be amortized over the bond's life.

How is the discount on bonds payable amortized?

The discount on bonds payable is amortized over the life of the bond, typically using either the straight-line method or the effective interest method. In the straight-line method, the total discount is divided by the number of interest periods to determine the amount to amortize each period. For example, if a $3,000 discount is amortized over 10 periods, each period will amortize:

$\mathrm{3,000}÷10=300$

This amount is added to the interest expense each period, gradually increasing the bond's carrying value until it reaches its face value at maturity.

What journal entries are made when issuing a discounted bond?

When issuing a discounted bond, the following journal entries are made:

1. Debit Cash for the amount received (e.g., $47,000).

2. Debit Discount on Bonds Payable for the discount amount (e.g., $3,000).

3. Credit Bonds Payable for the face value of the bond (e.g., $50,000).

These entries reflect the cash received, the discount recorded as a contra liability, and the total liability for the bond's face value.

How does the discount on bonds payable affect the balance sheet?

The discount on bonds payable is recorded as a contra liability on the balance sheet, reducing the carrying value of the bonds payable. For example, if bonds payable are $50,000 and the discount is $3,000, the carrying value shown on the balance sheet would be:

$\mathrm{50,000}-\mathrm{3,000}=\mathrm{47,000}$

Over time, as the discount is amortized, the carrying value of the bonds payable increases until it equals the face value at maturity.