Consider this question:

Assume that your bond has an interest rate of 10 percent when other bonds are paying 12 percent. Investors will not want to buy your bond if they can earn 12 percent elsewhere. What can you do to get investors to buy your 10 percent bond? (Answer: lower the price)

You will need to drop the price of your bond so investors are really getting a 12 percent return. In other words, you need to drop the price to the present value of the bond using a 12 percent interest rate. You will need to sell the bond at a discount.

The selling price of a bond is determined by the relationship between the bonds contract interest rate and the market interest rate when the bond is sold.

If contract rate = market rate, bond sells at face value.

If contract rate > market rate, bond sells at a premium.

If contract rate < market rate, bond sells at a discount.

DEMONSTRATION PROBLEM 3 Issuance of a Bond (Premium)

On January 1, a corporation issued a $1 million, five-year, 11 percent bond that pays interest semiannually. The market interest rate on January 1 was 10 percent. What would be the journal entry to record the issuance of this bond? (The market value of the bond, so you wont have to calculate it yourself, is $1,038,606).