In today’s accounting tutorial, we look into how a discount can arise on a bonds payable issuance and, in particular, the calculations and journal entry. We will cover what these bonds are used for, why a discount is necessary, and then two methods in how that discount is amortised over the bond’s life.
The quick answer, without covering how the discount arises or the method of amortisation, is the journal entry requires a debit to the interest expense account and a credit to the discount on bonds payable account. If you would like to know a bit more of what is involved … please read on.
What are Bonds Payable?
Bonds payable are classed as non-current, i.e. long-term, liabilities that an entity generally issues for capital projects. These are projects to purchase or construct non-current (fixed) assets that will deliver economic benefits to the entity over the long term.
These bond issues aren’t just for the private sector, although corporate bond issues are prevalent. The public and non-government organisation (NGO) sectors also use these debt instruments to raise funds for large projects. For example, governments issue similar types of instruments for capital programs and their growing fiscal deficits.
Key points about bonds payable to know:
- there will be a specified interest rate (called the coupon rate), along with how that is calculated and paid;
- the bond will be issued for a fixed period of time (ie with a maturity date); and
- it is transferable, so a purchaser does not need to hold it until maturity to receive their money back.
What is a Discount on Bonds Payable?
When we are talking about a discount on bonds payable, we refer to the situation where the equivalent market interest rate for similar bonds is higher than the coupon rate of the bonds we are dealing with. So two questions pop up from this situation. First, how does this type of discount arise? And second, how do we work out the discount value into dollars and cents? As we need to prepare some journal entries and interest rates don’t equate to debits and credits.
We also need to mention here that the Discount on Bonds Payable account is a contra account, i.e. it has a natural balance opposite to the main account it relates to. So in our case, we are dealing with a liability for the bonds being issued, so the discount is a debit account. That means on the balance sheet, we will offset the discount account against the bond liability account, but more about that later on.
Let’s move onto how discounts arise and the calculations involved.
How do Discounts on Bonds Payable Arise?
A discount on the purchase of bonds payable will generally arise due to the coupon rate, set at the time of issue, now being below the prevailing market rate. This would be more common in a rising interest rate environment than a premium on purchase, which one would see more of in a falling interest rate environment.
Bonds Payable Discount Calculations
We now move onto the calculations. Don’t be put off by these; once you have worked your way through a few examples, they become very straightforward. The formula doesn’t change, just the figures you plug into it.
Let’s say ABC Ltd has decided to issue 10 year, $10,000 bonds, paying 5 per cent (payable quarterly). The formula to calculate a bond price is:
Bond price = Principal / (1 + i) n + Interest x ((1 – 1 / (1 + i)n ) / i)
- principal = face value of the bond
- interest = interest amount per payable period
- i = the market interest rate
- n = number of interest payable periods over the life of the bond
So in our example the bond price is:
- principal = $10,000
- interest = ($10,000 x 5%) / 4 = $125 per payable period
- i = 8% per annum
- n = 10 years x 4 quarters per annum = 40 payable periods.
Bond price = $10,000 / (1 + 8% / 4)40 + $125 x ((1 – 1 / (1 + 8%)40 / (8% / 4))
Bond Price = $7,948
This is the bond price that an investor would be prepared to pay for ABC’s $10,000 bonds with a coupon rate of 5 per cent and an equivalent market rate of 8 per cent.
Journal Entry for Discount on Bonds Payable
Now that we have a handle on the discount calculations, we have to turn to the debits and credits to create the journal entry that brings to account the correct flow of economic benefits and liabilities for a bonds payable issue. We will break these entries into four sections:
- issuing of a bond;
- bond interest payments;
- amortisation of bond discount; and
- repayment of a bond.
For this example, we are going to use ABC Ltd and its upcoming bond issue. ABC Ltd wants to raise $1,000,000 from local investors for new machinery it needs to replace existing equipment with. ABC is going to issue $10,000 bonds, paying a coupon rate of 7 per cent. The bonds will be for ten years, paying interest every six months to bondholders. The current equivalent interest rate in the market is 9 per cent.
Issuing of a Bond
Calculations
No surprise, ABC will issue the bonds at a discount to their $10,000 par value. The formula we are going to use is (copied down from above):
Bond price = Principal / (1 + i) n + Interest x ((1 – 1 / (1 + i)n ) / i)
- principal = face value of the bond
- interest = interest amount per payable period
- i = the market interest rate
- n = number of interest payable periods over the life of the bond
In this new example the bond price will be:
- principal = $10,000
- interest = ($10,000 x 7%) / 2 = $350
- i = 9% (market interest rate)
- n = 10 years x 2 payments per year = 20 payable periods
Bond price = $10,000 / (1 + 9% / 2)20 + $350 x ((1 – 1 / (1 + 9%)20 / (9% / 2))
Bond Price = $8,699
Before we get into the first journal, we need to cover one more calculation. We need to look at how many bonds payable need to be issued. Let’s work through it.
The number of bonds to issue is calculated by:
Funds to be raised / funds raised by the bond
Which for ABC Ltd will be:
$1,000,000 / $8,699 = 115 (0 dp) bonds
Journal Entry
Now we can start the journal entries as we have all of the information we need. ABC would make the first journal entry on July 1:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 1 | Bank | 1,000,385 | |
| Discount on Bonds Payable Issue | 149,615 | ||
| Bonds Payable | 1,150,000 |
The debit entry of $1,000,385 reflects the funds raised from the local investors (115 bonds x $8,699 per bond = $1,000,385). This is the cash ABC will use to replace its ageing equipment. The credit of $1,150,000 reflects the new liability for ABC from its bond issue. The selling of 115 bonds at their par value of $10,000 creates the liability. Remember, the par value is what ABC will have to pay back in ten years, i.e. $10,000 to each bondholder.
And finally the debit entry of $149,615 reflects the discount incurred on the whole bond issue ($1,150,000 – $1,000,385 = $149,615).
Bond Interest Payments
Six months later, we come to the first interest payment on ABC’s bonds on July 1. The interest payment doesn’t care about market rates and discount prices, just the coupon rate and par value. For the first six-monthly payment, ABC’s accounts team would prepare the following entry:
$10,000 par value x 115 bonds x (7% coupon rate / 2) = $40,250
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Dec 31 | Interest Expense | 40,250 | |
| Bank | 40,250 |
The debit to interest reflects the increase in this expense; an entry made twice a year by ABC Ltd. The bank credit reflects the actual payment of money to the bondholders.
Amortisation of Bond Discount
Along with interest payments being made twice a year, the discount on bonds payable is amortised over the ten years. This is done to reflect better the actual interest rate charged to ABC Ltd by the bondholders, not just the coupon rate at their issue. Because the liability of the bonds is larger than the money received, as we saw in the first journal entry, if we don’t amortise the difference, this amount will completely miss the profit and loss statement. Which then may materially mislead readers of those accounts as to the true cost of borrowing by the firm.
There are two main methods available for this amortisation, the straight-line method and the effective interest method. They both achieve the same result: the amortisation of the discount over the life of the bond. But they go about it in different ways. Let’s start with the easy one, the straight-line method.
The Straight-Line Method
As the name suggests, this method will amortise the bond discount over the life of the bond in equal amounts each year – well, every six months in our case due to the interest payment to bondholders being every six months. The formula to use is:
Bond Discount / number of interest payment periods
With ABC Ltd, this will be:
$149,615 / (10 years x 2 payments per annum) = $7,481 (0 dp)
And from this, we will produce the following journal entry for the six months ended December 31:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Dec 31 | Interest Expense | 7,481 | |
| Discount on Bonds Payable | 7,481 |
The debit to interest expense increases the interest costs for the bond for the six months. At the same time, the credit reduces the contra account discount on bonds payable. This journal would be repeated every six months so that come June 30 in ten years, the discount account would have a $0 balance.
The Effective Interest Method
We have a rather good article (if we say so ourselves) covering the effective interest method in amortising certain balances. If you would like some more detail about the method, then please see our article here.
The main point to take away from the more detailed article is that the effective interest method is used because it provides a better reflection of the true costs of borrowings for the entity that the straight-line method cannot achieve. Set out below is an effective interest calculation table for the 10 years (20 interest payment period) bonds payable for ABC Ltd. You will see a small rounding error at the end with $57 left of the unamortised discount. But we can take care of this at bond maturity. Please see the notes below table for an explanation of each column.
Notes:
- Interest Periods: 10 years x 2 payments per year;
- Interest Payment: ($1,150,000 (Bonds Payable) x 7% (coupon rate))/ 2 = $40,250 per six months;
- Market Interest: Bond Book Value x market interest rate (9%);
- Discount Amortisation: Market Interest – Interest Payment;
- Unamortised Discount: Unamortised Balance previous year – this year’s Discount Amortisation; and
- Bond Book Value: Bond Book Value previous year – this year’s Discount Amortisation.
The journal entry is the same debits and credits as the straight-line method. Still, as you may have already noticed, the effective interest method’s initial amortisation amounts are at lower levels. For example, in period one, the straight-line method had $7,481 amortised, whereas the effective interest method uses $4,767. But overall, the same amount has to be amortised no matter which method is used.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Dec 31 | Interest Expense | 4,767 | |
| Discount on Bonds Payable | 4,767 |
Repayment of a Bond
The final section to cover-off is the repayment of the bonds payable. At this point, all of the Discount on Bonds Payable has been amortised, and so we are left with a net balance of the liability of $1,150,000. Assuming the interest and amortisation journals have already been made, the final journal entry is:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Dec 31 | Bonds Payable | 1,150,000 | |
| Bank | 1,150,000 |
The debit entry brings the liability balance down to $0, while the credit entry reflects the payment at maturity to bondholders.
Conclusion
So in today’s accounting tutorial article, we looked not only at the journal entry of a bonds payable issue but why firms issue financial instruments and, in particular, why holders may require a discount to take up an issue. When issuing bonds, firms are always competing with the prevailing rates; sometimes, a bond can be issued at par, while other times at a discount (as ABC Ltd had to do in our example). While again, other times, a premium may be able to be obtained. Please see our article here to explain when this situation arises and the calculations and journal entries involved.
We then covered using the straight-line and effective interest methods of amortising the discount on bonds payable contra account. As discussed, although they reach the same end of fully amortising the discount balance, the effective method better reflects the firm’s borrowing costs.
As always, we welcome your comments below or get in touch through a questions section or contact us page.