Discount: Contract Rate < Market Rate

Your bonds pay 10% when the market rate is 12%. Investors will not want to buy your bond if they can earn 12% elsewhere. What can you do to get investors to buy your 10% bond? Answer: lower the price.

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

The Company issues $1,000,000 5-year bonds with a contract rate of 10% with semi-annual interest payments when the market rate is 12%. Using Present Value tables we determine that an issue price of $926,395 will effectively make our bonds equal to bonds that pay the market 12%.

The journal entry to record issuing the bond is:

GENERAL JOURNAL						Page
	Date		Description	Post	Debit	Credit
1							1
2							2
3							3

Discount on Bonds Payable is a contra account which reduces the bonds payable account on the balance sheet. The normal balance of Discount on Bonds Payable is a debit.

For loaning the company $926,395, over the 5 year period the investor will get:

Principal $1,000,000

Interest Payments 500,000

Total 1,500,000

Investment 926,395

Interest Earned $ 573,605

The Borrowing Company will incur $573,605 of interest expense

Amortizing a bond discount using the Straight-Line Method

Example - $1 million, 5-year, 10% bond that paid interest semiannually was sold for $926,395 to yield the market interest rate of 12%. In the case of that bond, the following statements are true:

1. The investor loans the company $926,395 by buying the bond.
2. At the end of the 5 years, the company repays the investor $1 million.
3. Therefore, the investor gets $73,605 more at maturity than he or she paid for the bonds. The $73,605 discount is really just extra interest that is paid in one lump sum at maturity. It's the extra interest needed to bring the bond up to a 12% interest rate.
4. Because the $73,605 discount is really just extra interest, it must be recorded as interest expense. This interest must be spread across the 5-year term of the bond. The process of recognizing a portion of the discount as interest each time an interest payment is made to the bondholder is called amortizing the discount.

Straight-line amortization of a bond discount is similar to straight-line depreciation. The discount is amortized evenly over the bonds life. The bond mentioned previously has a life of 5 years or a total of 10 semiannual interest payments. If the discount is spread over the 10 semiannual interest payments, $7,360.50 of the discount is amortized on each payment date ($73,605/10). Since the discount is additional interest, the interest expense recognized is greater than the amount of interest paid.

The journal entry to record the interest payment and discount amortization separately is:

GENERAL JOURNAL						Page
	Date		Description	Post	Debit	Credit
1							1
2							2
3							3
4							4
5							5

OR combined

	Date		Description	Post	Debit	Credit
1							1
2							2
3							3