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Introduction to Bonds Payable

Bonds are a form of long-term debt. You might think of a bond as an IOU issued by a corporation and purchased by an investor for cash. The corporation issuing the bond is borrowing money from an investor who becomes a lender and bondholder. A bond is a formal contract that requires the issuing corporation to pay the bondholders 1. Interest every six months based on the bond’s stated interest rate, and 2. The principal or face amount on the bond’s maturity date. There are two significant advantages for a corporation to issue bonds instead of common stock: 1. Bonds will not dilute the ownership interest of the stockholders, and 2. Bonds have a lower cost than common stock. Bonds have a lower cost than common stock because of the bond’s formal contract to pay the interest and principal payments to the bondholders and to adhere to other conditions. A second reason for bonds having a lower cost is that the bond interest paid by the issuing corporation is deductible on its U.S. income tax return, whereas dividends are not tax deductible. The market value of an existing bond will fluctuate with changes in the market interest rates and with changes in the financial condition of the corporation that issued the bond. For example, an existing bond that promises to pay 9% interest for the next 20 years will become less valuable if market interest rates rise to 10%. Likewise, a 9% bond will become more valuable if market interest rates decrease to 8%. When the financial condition of the issuing corporation deteriorates, the market value of the bond is likely to decline as well. Present value calculations are used to determine a bond’s market value and to calculate the true or effective interest rate paid by the corporation and earned by the investor. Present value calculations discount a bond’s fixed cash payments of interest and principal by the market interest rate for the bond.

Bond Interest and Principal Payments
When a corporation issues a bond, it promises to pay the bondholder 1. Interest every six months at the bond's stated interest rate, and 2. The principal or face amount when the bond comes due at its maturity date. Bond Interest Payments Normally, a bond’s interest payments occur semiannually. This means that the corporation issuing a bond will pay to the bondholders one-half of the annual interest at the end of each six-month period as long as the bond is outstanding. The formula for calculating the semiannual interest payments is: Face Amount of the Bond x Stated Annual Interest Rate x 6/12 of a Year The following terms mean the same as a bond’s stated interest rate: • • • • face interest rate nominal interest rate coupon interest rate contractual interest rate

Throughout our explanation of bonds payable we will use the term stated interest rate or stated rate. Usually a bond’s stated interest rate is fixed or locked-in for the life of the bond.

Bond Principal Payment A bond’s principal payment is the dollar amount that appears on the face of a bond. This is the amount that the issuing corporation must pay to the bondholders on the date that a bond matures or comes due. Here are some names that refer to a bond’s principal amount: • • • • face value par or par value maturity value or maturity amount stated value

Throughout our explanation we will use these terms interchangeably. In addition, we assume that the bond’s principal amount will be due on a single date.

Timeline for Interest and Principal Payments It is helpful to prepare a timeline to visualize the cash payments that a corporation promises to pay its bondholders. The following timeline presents the cash payments of interest and principal for a 9% $100,000 bond maturing in 5 years:

Interest: Principal:

$4,500

$4,500

$4,500

$4,500 .....

$4,500

$4,500 $100,000

←6 months→ 0 Period No. 1

←6 months→ 2

←6 months→ 3

←6 months→ 4

←6 months→ 9 10

As the timeline indicates, the corporation will pay its bondholders 10 semiannual interest payments of $4,500 ($100,000 x 9% x 6/12 of a year). Each of the interest payments occurs at the end of each of the 10 sixmonth time periods. When the bond matures at the end of the 10th six-month period, the corporation must make the $100,000 principal payment to its bondholders. Keep in mind that a bond’s stated cash amounts—the ones shown in our timeline—will not change during the life of the bond.

Accrued Interest
Since the corporation issuing a bond is required to pay interest, and since the interest is paid on only two dates per year, the interest on a bond will be accruing daily. This means for each day that a bond is outstanding, the corporation will incur one day of interest expense and will have a liability for the interest it has incurred but has not paid. If the corporation has issued a 9% $100,000 bond, then each day it will have interest expense of $24.66 ($100,000 x 9% x 1/365). If the corporation issues monthly financial statements, then each month it needs to report $750 ($100,000 x 9% x 1/12) of interest expense. The corporation usually does this with the following monthly adjusting entry: Interest Expense 750 Interest Payable 750

While the issuing corporation is incurring interest expense of $24.66 per day on the 9% $100,000 bond, the bondholders will be earning interest revenue of $24.66 per day. With bondholders buying and selling their bond investments on any given day, there needs to be a mechanism to compensate each bondholder for the interest earned during the days a bond was held. The accepted technique is for the buyer of a bond to pay the seller of the bond the amount of interest that has accrued as of the date of the sale. For example, if a 9% $100,000 bond has a date of January 1, 2010 and it is sold on January 31, 2010, the buyer of the bond is required to pay the seller of the bond one month’s interest amounting to $750 ($100,000 x 9% x 1/12).

Bonds Issued at Par with No Accrued Interest
If a corporation issues a bond on January 1, 2010 and the bond has a date of January 1, 2010 there will be no accrued interest on the bond when it is issued. If the investor pays the corporation the face amount of the bond, the bond is said to have been issued at par or at 100—meaning 100% of the bond’s face value plus any accrued interest. (As we will see later, it is possible for a new bond to be issued after the date of the bond—and therefore to have accrued interest. In addition a bond might be sold by the issuing corporation for more or less than its face value.) Let’s assume that on January 1, 2010 a corporation issues a 9% $100,000 bond at its face amount. The bond is dated January 1, 2010 and requires interest payments on each June 30 and December 31 until the bond matures at the end of 5 years. Each semiannual interest payment will be $4,500 ($100,000 x 9% x 6/12). The corporation is also required to pay $100,000 of principal to the bondholders on the bond's maturity date of December 31, 2014. Since the bond was issued/sold for 100% of its face amount and since there is no accrued interest to be paid by the buyer of the bond, the issuing corporation will make the following journal entry: Jan 1, 2010 Cash 100,000 Bonds Payable 100,000 The following timeline shows the future cash payments that the corporation must make to the bondholders: Interest: Principal: $4,500 $4,500 $4,500 $4,500 ..... ←6 months→
01/01/10 06/30/10

$4,500

$4,500 $100,000 ←6 months→

←6 months→
12/31/10

←6 months→
06/30/11

←6 months→
12/31/11 6/30/14

12/31/14

0 Period No.

1

2

3

4

9

10

Journal Entries for Interest Expense – Annual Financial Statements If the corporation issuing the above bond has an accounting year ending on December 31, the corporation will incur twelve months of interest expense in each of the years that the bonds are outstanding. In other words, under the accrual basis of accounting, this bond will require the issuing corporation to report Interest Expense of $9,000 ($100,000 x 9%) per year. If the corporation issues only annual financial statements, the interest expense can be recorded at the time of its semiannual interest payments, as shown in the following journal entries for the year 2010: Jun 30, 2010 Interest Expense 4,500 Cash 4,500 Dec 31, 2010 Interest Expense Cash 4,500 4,500

2010 Oct 31. 2010 Dec 31. 2010 but delays issuing the bond until February 1. It must also report a current liability on its balance sheet for the amount of interest that it has incurred but has not yet paid.Journal Entries for Interest Expense – Monthly Financial Statements If the corporation issues monthly financial statements.500 4. 2010 Jul 31. the investors buying the bonds on February 1 will have to pay the issuing corporation one month of accrued interest. 2010 Aug 31. 2010 Sep 30.500 Cash 4. Bonds Issued at Par with Accrued Interest If a corporation has prepared a bond with a date of January 1. This is accomplished by recording an accrual adjusting entry at the end of each month.) . 2010 May 31. 2010 Dec 31. 2010 Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Payable Cash Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable 750 750 750 750 750 750 750 750 750 750 4. (The delay may have been caused by a turbulent financial market or some other situation.000 x 9% x 1/12) on each of its monthly income statements. it must report interest expense of $750 ($100.500 The journal entries for the years 2011 through 2014 will have the same accounts and amounts.500 750 750 750 750 750 750 750 750 750 750 750 750 Mar 31. 2010 Jun 30. The 14 journal entries pertaining to the corporation’s bond interest during the year 2010 will be: Jan 31. 2010 Interest Expense 750 Interest Payable 750 Feb 28. 2010 Interest Payable 4. In addition there will be an entry on June 30 and on December 31 for the required interest that was actually paid to the bondholders. 2010 Apr 30. 2010 Nov 30. 2010 Jun 30.

500 Interest Expense 4.500 = $9.500 Dec 31.000 ($4.750 recorded on June 30 + $4.750 Interest Payable 750 Cash 4.500 paid on June 30 and the $750 received on February 1. The accrued interest amounts to $750 ($100. it will have eleven months of interest expense during the year 2010. Journal Entries for Interest Expense – Annual Financial Statements If a corporation that is planning to issue a bond dated January 1. This amount of interest expense for February 1 through December 31.000 x 9% x 12/12). the issuing corporation will receive 100% of the bond’s face value plus one month of accrued interest. The entries will be similar for the years 2012.500 In the year 2011.500 ($100. . Assuming the corporation has an accounting year that ends on December 31. 2010. the journal entries will be: Jun 30. 2011 Interest Expense Cash Dec 31. the interest expense will be $9. 2010 Interest Expense 3.750. 2010 is $3. If the corporation issues only annual financial statements. 2014. or $100.000 x 9% x 6/12) on June 30. 2011 4.000 bond dated January 1. 2013.250.000 x 9% x 1/12).500 recorded on December 31).500 Note that the total amount of interest expense in 2010 will be $8. In the year 2011.500 + $4. In total the issuing corporation will receive $100.750 Bonds Payable 100. During each of the subsequent years 2011.750—equal to five months of interest for the months of February through June: $100. 2010 Interest Expense Cash 4. its journal entries for its interest payments during the year 2010 will be: Jun 30. The $750 received by the corporation for the accrued interest is credited to Interest Payable. The bond is issued on February 1 at its par value plus accrued interest. 2012.500 Cash 4.000.000 ($100. The bond will mature in 5 years and requires interest payments on June 30 and December 31 of each year until December 31.000 x 9% x 5/12.000 x 9% = $9.500 4. 2013. The difference between the $4. 2010 Cash 100. 2010 delays issuing the bond until February 1. 2010 is confirmed by the following calculation: $100. Since the bond was sold to investors at par.000 x 9% x 11/12 = $8.000) because the bond will be outstanding for a full year. and 2014 the corporation will have twelve months of interest expense equal to $9. The journal entry for this transaction is: Feb 1.500 4.250 ($3. the corporation will not have interest expense during January.000 Interest Payable 750 Note that the total amount received is debited to the Cash account and the bond's face amount is credited to Bonds Payable.Let’s illustrate this scenario with a corporation preparing to issue a 9% $100. The corporation is receiving the $750 because the corporation is required to pay the bondholders $4. and 2014.

2010 Note that in 2010 the corporation's entries included 11 monthly adjusting entries to accrue $750 of interest expense plus the June 30 and December 31 entries to record the semiannual interest payments. 2010 Jun 30.500 100. 2010 Jun 30. 2010 Cash Bonds Payable Interest Payable Feb 28. the following journal entries are needed in the year 2010 (including the entry when the bonds were issued on February 1. 2010 Apr 30. 2010 Jul 31. As a result of these journal entries. In each of the years 2011 through 2014 there will be 12 monthly entries of $750 each plus the June 30 and December 31 entries for the $4.500 4. 2010 Nov 30.000 750 Mar 31. 2010 Dec 31. 2010 Oct 31. 2010 May 31.500 750 750 750 750 750 750 750 750 750 750 750 750 4.Journal Entries for Interest Expense – Monthly Financial Statements If monthly financial statements are issued by the corporation. each monthly income statement will report one month of interest expense and the balance sheet will report a current liability for the amount of interest incurred by the corporation but not yet paid to the bondholders. 2010 Dec 31. 2010 Aug 31. 2010 Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Payable Cash Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Expense Interest Payable Interest Payable Cash 750 750 750 750 750 750 750 750 750 750 4.500 interest payments.750 100. . 2010 Sep 30.500 4. 2010): Feb 1.

and many other factors which occur both inside and outside of the corporation. the market interest rate will be constantly changing due to global events. First. The investors fear that when their bond investment matures. The reason is that an existing bond’s fixed interest payments are smaller than the interest payments now demanded by the market. Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline. The issuing corporation is required to pay only $4. the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.000. As a result. The following terms are often used to mean market interest rate: • • • • effective interest rate yield to maturity discount rate desired rate When Market Interest Rates Increase Market interest rates are likely to increase when bond investors believe that inflation will occur. The existing bond’s semiannual interest of $4.Market Interest Rates and Bond Prices Once a bond is issued the issuing corporation must pay to the bondholders the bond’s stated interest for the life of the bond.500 is $500 less than the interest required from a new bond.000 x 9% x 6/12) and the bondholder is required to accept $4.000 pay $5.500 every six months. Next. Let’s examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100. the bond should have sold for $100. When Market Interest Rates Decrease Market interest rates are likely to decrease when there is a slowdown in economic activity.000 x 6/12 of a year). they will be repaid with dollars of significantly less purchasing power. the market interest rate increased to 10%. In other words. let’s assume that a corporation issued a 9% $100. Let’s examine the effect of a decrease in the market interest rates. However. Since the bond's stated interest rate of 9% was the same as the market interest rate of 9%.000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100.000 every six months (market interest rate of 10% x $100. perceptions about inflation. bond investors will demand to earn higher interest rates.000 bond when the market interest rate was also 9%. the market will demand that new bonds of $100.500 of interest every six months as promised in its bond agreement ($100. . An existing bond’s market value will decrease when the market interest rates increase. While the bond’s stated interest rate will not change. let’s assume that after the bond had been sold to investors.000.

the existing bond will become more valuable. the corporation will receive more than the face amount of the bond. To illustrate the premium on bonds payable. The relationship between market interest rates and the market value of a bond is referred to as an inverse relationship.. • Issue bonds prior to market interest rates increasing in order to lock-in smaller interest payments. The bond is dated as of January 1. the market value of an existing bond increases. or premium. When market interest rates decrease.000 x 9% x 6/12) and the bondholder will receive $4.000 x 9% x 6/12).000. In other words. You would do this in order to receive the relatively high current interest amounts for the life of the bonds. • • Purchase bonds prior to market interest rates dropping. Perhaps you have heard or read financial news that stated “Bond prices and bond yields move in opposite directions” or “Bond prices rallied. the corporation might anticipate that the appropriate interest rate will be 9%. 2010 and has a maturity date of December 31. The corporation must continue to pay $4. the market value of an existing bond will move in the opposite direction of the change in market interest rates.500.. An existing bond becomes more valuable because its fixed interest payments are larger than the interest payments currently demanded by the market. If you were an investor and could predict interest rates. you would.500 ($100.. Since the market is now demanding only $4. a corporation has prepared a $100. the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100. you would. If the investors are willing to accept the 9% interest rate. Relationship Between Market Interest Rates and a Bond’s Market Value As we had seen..Next. If however. .000 every six months (market interest rate of 8% x $100.. bond premium. the market value of an existing bond decreases. The bond's interest payment dates are June 30 and December 31 of each year.. An existing bond’s market value will increase when the market interest rates decrease.” If you were the treasurer of a large corporation and could predict interest rates. • • • When market interest rates increase.500 every six months. 2014.” or “The rise in interest rates caused the price of bonds to fall. let’s assume that after the bond had been sold to investors.000 bond with a stated interest rate of 9% per annum (9% per year). lowering their yield.) Sell bonds that you own before market interest rates rise.000 x 6/12 of a year) and the existing bond is paying $4. the market interest rate is less than 9% when the bond is issued. let's assume that in early December 2009. You would do this because you don’t want to be locked-in to your bond’s current interest amounts when higher rates and amounts will be available soon. This means that the corporation will be required to make semiannual interest payments of $4.500 of interest every six months as promised in its bond agreement ($100. (However. be aware that bonds are often callable by the issuer. The amount received for the bond (excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on bonds payable. the bond will sell for its face value. Bond Premium with Straight-Line Amortization When a corporation prepares to issue/sell a bond to investors. the market interest rate decreased to 8%.

100 was received by the corporation because its interest payments to the bondholders will be greater than the amount demanded by the market interest rates. 1. the corporation proceeds to issue the 9% bond on January 1. 2010 will be: Jan.100 plus $0 accrued interest.) Straight-Line Amortization of Bond Premium on Annual Financial Statements If a corporation issues only annual financial statements and its accounting year ends on December 31. The corporation’s journal entry to record the issuance of the bond on January 1. 2010 Interest Expense Premium on Bonds Payable Cash 4. 2010 the book value of this bond is $104. when a corporation issues only annual financial statements.090 Premium on Bonds Payable 410 Cash 4. In our example. On January 1. 2014. (In Part 10 we will illustrate the effective interest rate method.100 The account Premium on Bonds Payable is a liability account that will always appear on the balance sheet with the account Bonds Payable. The bond premium of $4.100 divided by 5 years). the amortization of the bond premium will involve the account Interest Expense. Therefore. The combination of these two accounts is known as the book value or carrying value of the bonds.100 on January 1.100 100. Rather than changing the bond's stated interest rate to 8%. However.100 must be reduced to $0 during the bond’s 5-year life.000 credit balance in Bonds Payable + $4. Reducing the bond premium in a logical and systematic manner is referred to as amortization.100 ($100. Premium on Bonds Payable with Straight-Line Amortization Over the life of the bond.000 when the bonds mature on December 31. the balance in the account Premium on Bonds Payable must be reduced to $0. In other words. the corporation will receive more than the bond’s face value. In this section we will illustrate the straight-line method of amortization.500 Dec 31. By reducing the bond premium to $0.090 410 4.100 and maturing in 5 years. the market interest rate for this bond drops to 8%.Let's assume that just prior to selling the bond on January 1. both Bonds Payable and Premium on Bonds Payable will be reported on the balance sheet as long term liabilities. Each accounting period during the life of the bond there needs to be a credit to Interest Expense and a debit to Premium on Bonds Payable. In the case of the 9% $100. 2010 to $100.000 4. the amortization of the bond premium can be recorded once each year. Since this 9% bond will be sold when the market interest rate is 8%. Under this assumption the journal entries on June 30 and December 31 will be: Jun 30.000 bond issued for $104. 2010 Cash Bonds Payable Premium on Bonds Payable 104. the bond premium of $4. the annual straight-line amortization of the bond premium will be $820 ($4.100 credit balance in Premium on Bonds Payable). the bond’s book value will be decreasing from $104. 2010. Let’s assume that this 9% bond being issued in an 8% market will sell for $104. if the bonds are a long term liability. the amortization of the bond premium is often recorded at the time of its semiannual interest payments.500 . 2010 Interest Expense 4.

2013 balance Dec 31. 2011 amortization Dec 31. 2012 $ 100. 2010 Dec 31. 2014 amortization 410 410 3.000: Date Credit Balance in Bonds Payable Account Jan 1.280 $ 2. 2011 amortization Jun 30.100 $ 3.000 Credit Balance in Bond Premium Account $ 4. 2010 amortization Jun 30. 2012 balance Dec 31.460 $ 1.460 410 410 1. 2010 Dec 31. 2011 Dec 31. 2012 amortization Dec 31. Premium On Payable Bonds 4. 2010 balance Jan 1.100 Jun 30. 2010 balance 4. 2011 balance Dec 31. 2014 balance Dec 31. 2014 amortization Dec 31.280 410 410 2. 2010 pmt minus amort Dec 31. 2010 bond issued The following table shows how the bond's book value will decrease from $104.500 of interest paid on December 31 minus $410 of amortization on June 30 and minus $410 of amortization on December 31). 2010 pmt minus amort Dec 31.000 $ 100.000 $ 100. 2013 amortization Dec 31. This $8.640 Book Value of the Bond $ 104.180 will be reported in the account Interest Expense for the year 2010 as shown in the following T-account: Interest Expense Jun 30.500 of interest paid on June 30 + $4.460 $ 101.090 8.640 . 2010 amortization Dec 31. 2012 amortization Jun 30.180 ($4.100 $ 103. 2013 amortization Jun 30.640 410 410 820 410 410 0 Dec 31.280 $ 102.000 $ 100.090 4.180 The following T-account shows how the balance in the account Premium on Bonds Payable will decrease over the 5-year life of the bonds under the straight-line method of amortization.The combination of the interest payments and the bond amortization results in the net amount of $8.100 to the bond’s maturity amount of $100.

Below are the 12 monthly entries for the amortization plus the June 30 and December 31 payments of semiannual interest during the year 2010: Jan 31.820 $ 100. 2010 Jun 30. 2014 prior to paying $100. 2010 Aug 31. 2010 Interest Expense 682 Premium on Bonds Payable 68 Interest Payable 750 Feb 28. 2010 Jun 30.500 682 68 750 682 68 750 681 69 750 682 68 Mar 31.33 per month ($4. 2010 Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Payable Cash Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable 682 68 750 681 69 750 682 68 750 682 68 750 681 69 750 4.000 $ 820 $ 100.000 $ 0 $ 100.100 of bond premium divided by the bond's life of 60 months). 2010 . 2010 Jul 31. 2013 Dec 31. 2010 Oct 31. 2010 Sep 30. 2010 May 31.500 4. the straight-line amortization of the bond premium will be $68.Dec 31.000 $ 100.000 Straight-Line Amortization of Bond Premium on Monthly Financial Statements If monthly financial statements are issued. 2010 Apr 30.

let’s assume that the 9% bond is sold in the 10% market for $96. 2010.149 (the $100. or discount. Discount on Bonds Payable will always appear on the balance sheet with the account Bonds Payable. bond discount. In other words.000. Just prior to issuing the bond. both Bonds Payable and Discount on Bonds Payable will be reported on the balance sheet as long term liabilities.500 ($100.Interest Payable Nov 30. 2010 Cash Discount on Bonds Payable Bonds Payable 96. The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. To illustrate the discount on bonds payable. The corporation's journal entry to record the sale of the bond will be: Jan. The difference is known by the termsdiscount on bonds payable. 2010. 2010 the book value of this bond is $96. 2010 Interest Expense Premium on Bonds Payable Interest Payable Interest Expense Premium on Bonds Payable Interest Payable 682 68 750 750 681 69 750 Dec 31. To illustrate the accounting for bonds payable issued at a discount. 2010 Interest Payable 4.000 bond dated January 1. 2010 Dec 31.500 Cash 4.851 100.500 The journal entries for the years 2011 through 2014 will be similar if all of the bonds remain outstanding.000 bond with an interest rate of 9%. The combination or net of these two accounts is known as the book value or the carrying valueof the bonds.000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31.) .000 credit balance in Bonds Payable minus the debit balance of $3. The interest payments of $4. the market interest rate for this bond increases to 10%. it is said to have been sold at a discount. 2014. if the bond is a long term liability. If the corporation goes forward and sells its 9% bond in the 10% market. it may have to anticipate the interest rate to appear on the face of the bond and in its legal contract.149 3. let's assume that just prior to offering the bond to investors on January 1.149 plus $0 accrued interest on January 1. Since the corporation is selling its 9% bond in a bond market which is demanding 10%.000 The account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra liability account since it will have a debit balance. On January 1. The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate. When a bond is sold for less than its face amount.851 in Discount on Bonds Payable. a financial crisis occurs and the market interest rate for this type of bond increases to 10%. Next. Bond Discount with Straight-Line Amortization When a corporation is preparing a bond to be issued/sold to investors. let’s assume that in early December 2009 a corporation prepares a 9% $100. it will receive less than $100. 1. the corporation will receive less than the bond’s face amount. Let’s assume that the corporation prepares a $100.

885 4. 2011 amortization Dec 31. 2010 pmt & amort Dec 31. 2010 Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable 4. Since a bond's discount is caused by the difference between a bond's stated interest rate and the market interest rate. 2010 amortization 385 Dec 31. 2011 balance 2.20 ($3. Discount on Bonds Payable Jan 1. the journal entry for amortizing the discount will involve the account Interest Expense.885 385 4.851 results from the corporation receiving only $96.Discount on Bonds Payable with Straight-Line Amortization Over the life of the bond. In our example the journal entries for 2010 under the straight-line method will be: Jun 30. Reducing this account balance in a logical manner is known as amortizing or amortization. In this example.081 385 Jun 30.500 each plus the two semiannual amortizations of bond discount of $385 each). When the same amount of bond discount is recorded each year. 2012 amortization .500 Dec 31. 2010 balance 3.770 The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond. 2010 amortization Dec 31.851 divided by the 5-year life of the bond). but having to pay the investors $100.000 on the date that the bond matures. 2010 bond issued 3.885 9. 2011 amortization 385 Dec 31. In our example.851 385 Jun 30. 2010 pmt & amort Dec 31.770 (the two semiannual interest payments of $4.851 is treated as an additional interest expense over the life of the bonds. 2010 The interest expense for the year 2010 will be $9. 2010 balance 4.149 from investors.500 4. Straight-Line Amortization of Bond Discount on Annual Financial Statements If a corporation issues only annual financial statements on December 31.885 385 4. the balance in the account Discount on Bonds Payable must be reduced to $0. The following T-account for Interest Expense shows the entries for the year 2010: Interest Expense Jun 30. the amortization of bond discount is often recorded at the time of its semiannual interest payments.311 385 Jun 30. the straight-line amortization would be $770. it is referred to as straight-line amortization. The discount of $3. the bond discount of $3.

229 $ 100. 2014 prior to paying $100. 2012 amortization Dec 31. 2012 Dec 31. 2010 Dec 31.541 $ 771 $ 96. 2011 Dec 31.000 $ 100. 2014 amortization 386 Dec 31. 2010 Dec 31.000 Straight-Line Amortization of Bond Discount on Monthly Financial Statements If the corporation issues monthly financial statements.385 Dec 31.541 385 Jun 30.000 $ 0 $ 100.000 $ 100.459 $ 99.000: Date Credit Balance in Bonds Payable Account Jan 1.000 $ 100.081 $ 2. the bond’s book value will be increasing from $96.851 $ 3. 2013 Dec 31. 2013 balance 771 385 Jun 30. the monthly amount of bond discount amortization under the straight-line method will be $64.000 $ 100. 2013 amortization Dec 31.000 Debit Balance in Bond Book Value of the Discount Account Bond $ 3.311 $ 1. 2014 balance 0 As the bond discount is amortized. 2013 amortization 385 Dec 31.149 $ 96.851 of bond discount divided by the bond’s life of 60 .689 $ 98.919 $ 97.149 on the date the bond was issued to the bond’s maturity amount of $100. 2012 balance 1.000 $ 100.18 ($3. 2014 amortization Dec 31.

2010 Oct 31. 2010 May 31. 2010 Aug 31. 2010 Sep 30.500 814 64 750 814 64 750 814 64 750 814 64 750 814 64 750 815 Feb 28. 2010 Jul 31. 2010 Dec 31. 2010 Mar 31. 2010 Apr 30. 2010 Jun 30. The 12 monthly journal entries for the bond interest and amortization of bond discount plus the entries for the June 30 and December 31 semiannual interest payments will result in the following 14 entries during the year 2010: Jan 31.months). 2010 Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Payable Cash Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense Discount on Bonds Payable Interest Payable Interest Expense 814 64 750 814 64 750 814 64 750 814 64 750 814 64 750 815 65 750 4. 2010 Nov 30.500 4. 2010 Jun 30. 2010 .

PLUS 2.500 $4.500 65 750 4..000 x 9% x 6/12 of a year) at the end of each of the 10 semiannual periods. In other words. The present value of a bond’s interest payment. PLUS 2. the present value of a bond is the total of: 1.500 The journal entries for the remaining years will be similar if all of the bonds remain outstanding. ←6 months→ 01/01/10 06/30/10 $4. The present value of the semiannual interest payments. Calculating the Present Value of a 9% Bond in an 8% Market The present value of a bond is calculated by discounting the bond’s future cash payments by the currentmarket interest rate.500 $100. The present value of the principal payment on the date the bond matures. 2010 and having interest payment dates of June 30 and December 31 of each year for five years will have the following semiannual interest payments and the one-time principal payment: Interest: Principal: $4.500 $4. plus a single principal payment of $100. 2010 Interest Payable Cash 4. the issuing corporation will pay its bondholders 10 identical interest payments of $4.. 1 2 3 4 9 10 As the timeline indicates.Discount on Bonds Payable Interest Payable Dec 31. The present value of a bond’s maturity amount..500 ($100.500 $4. A 9% $100.500 $4.000 at the end of the 10th six-month period. The present value of a bond = 1.. The present value (and the market value) of this bond depends on the market interest rate at the time of the calculation. .000 ←6 months→ ←6 months→ 12/31/10 ←6 months→ 06/30/11 ←6 months→ 12/31/11 6/30/14 12/31/14 0 Period No. The market interest rate is used to discount both the bond’s future interest payments and the principal payment occurring on the maturity date.500 .000 bond dated January 1.

a financial calculator. “n” will be the number of semiannual interest periods or payments. since “n” refers to the number of semiannual interest periods. you need to go to the column which is headed with themarket interest rate per semiannual period. We will use present value tables with factors rounded to three decimal places and will round some dollar amounts to the nearest dollar. At the intersection of n = 10. you would go to the column with the heading of 4% (8% annual rate divided by 2 six-month periods). Present Value of a Bond’s Interest Payments In our example. 1. 2010 for the bond described above. In the case of a bond. use the column that has the market’s semiannual interest rate “i” in its heading. The factors contained in the PVOA Table represent the present value of a series or stream of $1 amounts occurring at the end of every period for “n” periods discounted by the market interest rate per period. and the interest rate of 4% you will find the appropriate PVOA factor of 8. Go down the 4% column until you reach the row where n = 10. We will refer to the market interest rates at the top of each column as “i”. a 5-year bond paying interest semiannually will require you to go down the first column until you reach the row where n = 10. Since n = 10 semiannual periods.500 each. there will be interest payments of $4. To calculate the present value of the semiannual interest payments of $4. Let’s use the following formula to compute the present value of the interest payments only as of January 1. This can be done with computer software. or a present value of an ordinary annuity (PVOA) table. To obtain the proper factor for discounting a bond’s interest payments. use computer software or a financial calculator to compute more precise present value amounts. If the market interest rate is 8% per year. The amount of the interest payment occurring at the end of each six-month period is represented by “PMT”. After you understand the present value concepts and calculations. you need to discount the interest payments by the market interest rate for a six-month period. This column represents the number of identical payments and periods in the ordinary annuity.Always use the market interest rate to discount the bond’s interest payments and maturity amount to their present value. the number of semiannual periods is represented by “n” and the market interest rate per semiannual period is represented by “i”. PVOA = PMT x PVOA factor . In computing the present value of a bond’s interest payments. you select the column with the market interest rate per semiannual period. For example.111. This series of identical interest payments occurring at the end of equal time periods forms an ordinary annuity.500 occurring at the end of every six-month period for a total of 10 six-month or semiannual periods. We will use the Present Value of an Ordinary Annuity (PVOA) Table for our calculations: » Click here to open our PVOA Table Notice that the first column of the PVOA Table has the heading of “n”. These interest rates represent the market interest ratefor the period of time represented by “n”. The remaining columns are headed by interest rates.

This column represents the number of identical periods that interest will be compounded. the number of periods for discounting the maturity amount is the same number of periods used for discounting the interest payments. In our example. Since n = 10 semiannual periods.000 will need to be discounted to its present value as of January 1. since “n” refers to the number of semiannual interest periods. i=4% market interest rate per semiannual period PVOA = $4. Convert the market interest rate per year to a semiannual market interest rate.500 each—with the first payment occurring on June 30. you select the column with the market interest rate per semiannual period. In the case of a bond. n. 2010. This $8. Go down the 4% column until you reach the row where n = 10. If the market interest rate is 8% per year.500 return on an investment of $36. “n” is the number of semiannual interest periods or payments. The interest rate represents themarket interest rate for the period of time represented by “n”.000 minus $36. Present Value of a Bond’s Maturity Amount The second component of a bond's present value is the present value of the principal payment occurring on the bond's maturity date.500 The present value of $36. For example.111 PVOA = $36. Recap • • • • Use the market interest rate when discounting a bond’s semiannual interest payments. you would go to the column with the heading of 4% (8% annual rate divided by 2 sixmonth periods). We will use the Present Value of 1 Table (PV of 1 Table) for our calculations.000 by the semiannual market interest rate. and the interest rate of 4%. a 5-year bond paying interest semiannually will require you to go down the first column until you reach the row where n = 10. use the semiannual market interest rate (i) and the number of semiannual periods (n). Convert the number of years to be the number of semiannual periods.500 x PVOA factor for n=10 semiannual periods.676. The present value of the maturity amount will be calculated next. i. The principal payment is also referred to as the bond's maturity value or face value.500 equals $8. The remaining columns of the PV of 1 Table are headed by interest rates. When using the present value tables. you discount the $100. Recall that this calculation determined the present value of the stream of interest payments. you need to go to the column which is headed with the market interest rate per semiannual period. .500 x 8. In other words. At the intersection of n = 10. 2. In the case of a bond.000 principal payment on the bond’s maturity date at the end of the 10th semiannual period.PVOA = $4.500).500 gives the investor an 8% annual return compounded semiannually. 2010 in return for 10 semiannual payments of $4.500 ($45. you will find the PV of 1 factor of 0. To calculate the present value of the single maturity amount. there will be a $100. The difference between the 10 future payments of $4. Notice that the first column of the PV of 1 Table has the heading of "n". The single amount of $100.500 each and the present value of $36.500 on January 1. 2010.500 tells us that an investor requiring an 8% per year return compounded semiannually would be willing to invest $36.

which will be noted as “i”. Unamortized Bond Premium.100 should approximate the bond’s market value. Bond Premium. The present value of a bond’s interest payment.000 x PV of 1 factor for n=10 semiannual periods. The present value of the bond in our example is $36..600 and the single future principal payment of $100.000 is $32.000 at the end of 10 semiannual periods of time.500 vs.400. i=4% market interest rate per semiannual period PV of 1 = $100. Recap: When calculating the present value of the maturity amount.. Combining the Present Value of a Bond’s Interest and Maturity Amounts Recall that the present value of a bond consisted of: 1. In other words. PLUS 2.The factors contained in the PV of 1 Table represent the present value of a single payment of $1 occurring at the end of the period “n” discounted by the market interest rate per period.000 x 0.676 PVOA = $67. $4. To obtain the proper factor for discounting a bond’s maturity value.100 more than the bond's face amount is referred to as Premium on Bonds Payable. Let’s use the following formula to compute the present value of the maturity amount only of the bond described above. the 9% bond will be paying $500 more semiannually than the bond market is expecting ($4. Use the semiannual market interest rate (i) and the number of semiannual periods (n) that were used to calculate the present value of the interest payments. This $32. which occurs at the end of the 10th six-month period. or Premium. The bond’s total present value of $104. The present value of a bond's maturity amount.400 return on an investment of $67. The maturity amount. The difference between the present value of $67.000. If investors will be receiving an additional $500 semiannually for 10 semiannual periods.600 gives the investor an 8% annual return compounded semiannually. It is reasonable that a bond promising to pay 9% interest will sell for more than its face value when the market is expecting to earn only 8% interest.100. is represented by “FV” .600 The present value of $67.500 + $67.600 tells us that an investor requiring an 8% per year return compounded semiannually would be willing to invest $67. they are willing to pay $4. use the PV of 1 table and use the same “n” and “i” that you used for discounting the semiannual interest payments.100 more than the bond’s face amount of $100. PV of 1 = FV x PV of 1 factor PV of 1 = $100.600 in return for a single receipt of $100.600 = $104. The $4.000). .

2010. 2010 Cash Bonds Payable Premium on Bonds Payable 104. the amount of the bond premium must be amortized to interest expense over the life of the bond. This amortization will cause the bond’s book value to decrease from $104. Before we demonstrate the effective interest rate method for amortizing the bond premium pertaining to a 5-year 9% $100. The effective interest rate is multiplied times the bond’s book value at the start of the accounting period to arrive at each period’s interest expense. The bond premium of $4. The corporation must make an interest payment of $4. The difference between Item 2 and Item 4 is the amount of amortization. This means that the Cash account will be credited for $4. 2010 to $100.000 4. 4. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value. the amount of interest expense will decrease. 5.100 on January 1.000 x 9% x 6/12) on each June 30 and December 31. the market interest rate on January 1. 2010 was 4% per semiannual period for 10 semiannual periods.100 on January 1.100 100.000 bond issued in an 8% market for $104. In our example. 2010 is: Jan.The journal entry to record a $100.100 Amortizing Bond Premium with the Effective Interest Rate Method When a bond is sold at a premium. 2. This means that when a bond’s book value decreases.000 just prior to the bond maturing on December 31. 3. 1. In short. the effective interest rate method is more logical than the straight-line method of amortizing bond premium. . In other words. The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding. 2014.000 bond that was issued for $104.500 on each interest payment date. let's outline a few concepts: 1.100 on January 1.500 ($100.100 must be amortized to Interest Expense over the life of the bond. The effective interest rate method uses the market interest rate at the time that the bond was issued.

100 $ 3.000 $ 100.058 $ 4.137 $ 4.281 $ 101.5% x Face Interest Expense Amortization Mkt 4% x Of Bond Previous BV in Premium G C minus B Debit Bond Premium Balance Book Value In Bonds of the Bonds Payable Fplus E Account Credit Cash Debit Interest Expense Jan 1.000 $ 104.005 $ 100.000 $ 100.872 $ 1.091 $ 4.500 $ 4.164 $ 4.415 $ 3.122 $ 4.The following table illustrates the effective interest rate method of amortizing the $4.151 $ 4.500 $ 4.107 $ 4. 2010 Dec 31.872 $ 101. 2011 Jun 30.100 $ 103.100 premium on a corporation’s bonds payable: A B C D E Balance In Bond Premium Account F G Date Interest PaymentStated 4.500 $ 4. 2013 Jun 30.500 $ 4. 2014 $ 4.000 $ 100. 2011 Dec 31.281 $ 1. 2010 Jun 30.005 $ 545 $ 100.075 $ 4.052 $ 2.000 $ 100. 2013 Dec 31.415 $ 103.500 $ 4. 2012 Dec 31.000 $ 100.764 $ 3. 2010 Jun 30.674 $ 102.500 $ 4.000 $ 100.447 $ 101.052 $ 102.500 $ 4.000 $ 100.000 $ 100. 2012 Jun 30.000 $ 100.500 $ 4.447 $ 1.040 $ (336) $ (349) $ (363) $ (378) $ (393) $ (409) $ (425) $ (442) $ (460) $ 4.674 $ 2.500 $ 4.545 .764 $ 103.

2010 The journal entries for the year 2011 are: Jun 30. The interest expense in column C is the product of the 4% market interest rate per semiannual period times the book value of the bond at the start of the semiannual period. • If the company issues only annual financial statements and its accounting year ends on December 31.500 $ 45. our calculations are not as precise as the amounts determined by use of computer software.100) $ 0 $ 100. 2010 Interest Expense Premium on Bonds Payable Cash Interest Expense Premium on Bonds Payable Cash 4.000 Please make note of the following points: • • • Column B shows the interest payments required in the bond contract: The bond’s stated rate of 9% per year divided by two semiannual periods = 4.Dec 31.100 Dec 31.000 4. 2014 Totals $ 4. including the entry to record the bond issuance.000 $ 100. the amortization of the bond premium can be recorded at the interest payment dates by using the amounts from the schedule above.500 104. Because the present value factors that we used were rounded to three decimal places. or factors with more decimal places. 2011 Interest Expense Premium on Bonds Payable Cash 4.137 363 4. a financial calculator. are: Jan 1.151 349 4. This calculation uses the market interest rate at the time the bond was issued: The market rate of 8% per year divided by two semiannual periods = 4% semiannually.000 $ 3.955 $ 40.900 $ (545) $ ( 4.5% per semiannual period times the face amount of the bond Column C shows the interest expense.500 . 2010 Cash Bonds Payable Premium on Bonds Payable Jun 30.100 100. This correlation between the interest expense and the bond’s book value makes the effective interest rate method the preferred method. In our example there was no accrued interest at the issue date of the bonds and there is no accrued interest at the end of each accounting year because the bonds pay interest on June 30 and December 31. the amounts in year 2014 required a small adjustment. Notice how the interest expense is decreasing with the decrease in the book value in column G. The entries for 2010.500 4. As a result.164 336 4.

820 Year 2010 2011 2012 2013 2014 Totals Notice that under both methods of amortization. but allows the straightline method when the amount of bond premium is not significant.415 $ 102.280 $ 102.500 The journal entries for 2012.872 $ 101. Effective Interest Rate Method Interest Expense $ 8. Comparison of Amortization Methods Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method.180 $ 8. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.100 $ 103. The accounting profession prefers the effective interest rate method.100) moves toward the bond's maturity value of $100. the book value at the time the bonds were issued ($104.640 $ 100.000 of interest payments minus the $4.900 Book Value at Beg.100 is being amortized to interest expense over the life of the bond.122 378 4.100 $ 103.100 of premium received from the purchasers of the bond when it was issued.315 $ 8. Also notice that under both methods the corporation's total interest expense over the life of the bond will be $40.900 $ 104.674 $ 101.995 $ 40.133 $ 7. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The reason is that the bond premium of $4.180 $ 8.180 $ 40. 2013.900 ($45. 2011 Interest Expense Premium on Bonds Payable Cash 4.005 Straight-Line Method Interest Book Value at Expense Beg.) .180 $ 8.180 $ 8.000. of Year $ 8.Dec 31. of Year $ 104. and 2014 will also be taken from the schedule above.198 $ 8.460 $ 101.259 $ 8.

. 1 2 3 4 9 10 To obtain the present value of the interest payments you must discount them by the market interest rate per semiannual period..000 x 6/12 of a year) on each June 30 and December 31.500 . Present Value of the Bond's Interest Payments The first step in calculating the bond's present value is to calculate the present value of the bond’s interest payments.500 ←6 months→ 12/31/10 ←6 months→ 06/30/11 ←6 months→ 12/31/11 6/30/14 ←6 months→ 12/31/14 0 Period No. 2010 and it matures on December 31. PLUS 2. 2010. PMT = $4.) The bond’s life of 5 years is multiplied by 2 to arrive at 10 semiannual periods.500 $4.500 $4. In our example.500 (9% x $100. Each semiannual interest payment of $4.000 bond is prepared in December 2009. we need to calculate the bond’s present value.Calculating the Present Value of a 9% Bond in a 10% Market Let’s assume that a 9% $100. The date of the bond is January 1.500 $4.500 $4. We use the above amounts (i = 5%. The number of semiannual periods is symbolized by n.500 ($100. The present value of the bond is the total of: 1. The 5% market interest rate per semiannual period is symbolized by i. The interest payments form an ordinary annuity consisting of 10 payments of $4.. the market interest rate is 5% per semiannual period. n = 10. The present value of the bond’s interest payments that will occur every six months. 1. i=5% per semiannual period] . The present value of the principal amount that occurs when the bond matures. (The market rate of 10% per year was divided by 2 semiannual periods per year to arrive at the market interest rate of 5% per semiannual period.. We calculate these two present values by discounting the future cash amounts by the market interest rate per semiannual period.500) in the following equation for calculating the present value of the ordinary annuity (PVOA): PVOA = PMT x [PVOA factor for n=10 semiannual periods. To calculate the approximate price that an investor will pay for the corporation’s bond on January 1. 2010 the market interest rate has increased to 10%. The bond will pay interest of $4.000 x 9% x 6/12) occurring at the end of each of the 10 semiannual periods is represented by “PMT”. 2014. By the time the bond is offered to investors on January 1.500 occurring at the end of each six month period as shown in the following timeline: Interest: $4. ←6 months→ 01/01/10 06/30/10 $4.

In this case we use n = 10 semiannual periods. The present value of a bond’s interest payment.com’s Explanation of Present Value of an Ordinary Annuity.) Recall that this calculation determines the present value of the stream of interest payments only.500 x [7. 1 2 3 4 9 10 Since the corporation’s payment of the maturity amount occurs on a single date. ←6 months→ 01/01/10 06/30/10 $100. The present value of a bond’s maturity amount. i=5% per semiannual period] PV = $100.000 ←6 months→ 12/31/10 ←6 months→ 06/30/11 ←6 months→ 12/31/11 6/30/14 ←6 months→ 12/31/14 0 Period No.614. Present Value of the Bond’s Maturity Amount The second step in calculating the present value of a bond is to calculate the present value of the maturity amount of the bond as shown in the following timeline: Principal: . When using the PV of 1 Table we use the same number of periods and the same market interest rate that was used to discount the semiannual interest payments. The present value of the maturity amount will be calculated next. and i = 5% is 0. 2. Using the PV of 1 table..722] PVOA = $34. we see that the present value factor for n = 10. The calculation of the present value (PV) of the single maturity amount (FV) is: PV = FV x [PV factor for n=10 semiannual periods.. .000. i = 5% per semiannual period. we need to use the factors from a Present Value of 1 Table (PV of 1 Table).000 x 0.614 PV = $61. PLUS 2.PVOA = $4.400 Combining the Present Value of a Bond’s Interest and Maturity Amounts Recall that the present value of a bond = 1. FV = $100. and the future value.749 (You will find more information about discounting an ordinary annuity at AccountingCoach...

000). $61. The $3. the 9% $100. The bond’s total present value of $96.149 is approximately the bond’s market value and issue price. $100.The present value of the 9% 5-year bond that is sold in a 10% market is $96. the investors will not pay the full $100. Since investors will be receiving $500 less every six months than the market is requiring. Unamortized Bond Discount.500 vs. PLUS 2. In other words.851 Bonds Payable 100.000 .000 of a bond's face value.000 face value) is referred to as Discount on Bonds Payable. 2010 Cash 96.851 ($96.149 Discount on Bonds Payable 3.749 of present value for the interest payments.400 of present value for the maturity amount. The journal entry to record the $100.000 bond will be paying $500 less semiannually than the bond market is expecting ($4.000 bond that is issued on January 1. $34. 2010 for $96. or Discount. $5.149 and no accrued interest is: Jan. 1. It is reasonable that a bond promising to pay 9% interest will sell for less than its face value when the market is expecting to earn 10% interest.149 consisting of: 1. Bond Discount.149 present value vs.

851 must be amortized to Interest Expense over the life of the bond. 2. The effective interest rate is the market interest rate on the date that the bonds were issued. let's highlight a few points: 1. Before we demonstrate the effective interest rate method for a 5-year 9% $100. The Cash account will be credited for $4. The corporation must make an interest payment of $4.000 bond issued in a 10% market for $96.000 just prior to the bond maturing on December 31. the amortization will cause each period’s interest expense to be greater than the amount of interest paid during each of the years that the bond is outstanding. 4. 3. .Amortizing Bond Discount with the Effective Interest Rate Method When a bond is sold at a discount. This means that as a bond’s book value increases. The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. The effective interest rate is multiplied times the bond’s book value at the start of the accounting period to arrive at each period’s interest expense. 2010 to $100. Since the debit amount in the account Discount on Bonds Payable will be moved to the account Interest Expense. The difference between Item 2 and Item 4 is the amount of amortization. The amortization will cause the bond’s book value to increase from $96. the amount of interest expense will increase.149. 2010 was 5% per semiannual period for 10 semiannual periods. In our example the market interest rate on January 1.500 on each of these dates. the amount of the bond discount must be amortized to interest expense over the life of the bond.500 ($100.000 x 9% x 6/12) on each June 30 and December 31 that the bonds are outstanding. 2014. Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period. The bond discount of $3. 5.149 on January 1.

883 $ 2.761 $ 1.084 $ 99.954 $ 4.000 $ 100.000 $ 96.000 $ 4.856 $ 4.000 $ 100. 2011 Jun 30.000 $ 100.807 $ 4.962 $ 48.000 $ 100. 2013 Dec 31.349 $ $ $ 916 462 0 .149 $ 96.822 $ 4.538 $ 100.851 $ 3.778 $ 97.851 $ 307 $ 322 $ 339 $ 356 $ 374 $ 392 $ 412 $ 433 $ 454 $ 462 $ 3.500 $ 4.500 $ 45.912 $ 4.000 $ 100. 2012 Dec 31.500 $ 4.000 $ 100.5% x Face Interest Balance In Balance In Expense Amortization of Book Value the Account the Account Mkt 5% x Bond Discount of the Bonds Bond Bonds Previous BV C minus B F minus E Discount Payable in G Debit Interest Expense Credit Bond Discount $ 3. 2010 Jun 30.839 $ 4.874 $ 4.000 $ 100.544 $ 3.456 $ 96. 2010 Dec 31.527 $ 2.500 $ 4.892 $ 4.117 $ 97.153 $ 1.000 $ 100.000 Credit Cash Jan 1.239 $ 98. 2010 Jun 30. 2014 Totals $ 4. 2012 Jun 30.851 $ 100.651 $ 99. 2014 Dec 31. 2013 Jun 30.500 $ 4.000 $ 100.222 $ 2.500 $ 4. 2011 Dec 31.851 discount on bonds payable: A B C D E F G Date Interest PaymentStated 4.The following table illustrates the effective interest rate method of amortizing the $3.847 $ 98.500 $ 4.473 $ 97.500 $ 4.500 $ 4.500 $ 4.933 $ 4.000 $ 100.

500 Jun 30.856 356 4. The interest expense in column C is the product of the 5% market interest rate per semiannual period times the book value of the bond at the start of the semiannual period. • If the company issues only annual financial statements and its accounting year ends on December 31.Let’s make a few points about the above table: • • • Column B shows the interest payments required by the bond contract: The bond’s stated rate of 9% per year divided by two semiannual periods = 4. Jan 1. Notice how the interest expense is increasing with the increase in the book value in column G.5% per semiannual period multiplied times the face amount of the bond.851 100. 2010 Cash Discount on Bonds Payable Bonds Payable Interest Expense Discount on Bonds Payable Cash Interest Expense Discount on Bonds Payable Cash 96.822 322 4.500 4. our amortization amount in 2014 required a slight adjustment. Because the present value factors that we used were rounded to three decimal positions. As a result. 2010 The journal entries for the year 2011 are: Jun 30.500 Dec 31.149 3. our calculations are not as precise as the amounts determined by use of computer software.500 4. 2011 Interest Expense Discount on Bonds Payable Cash Interest Expense Discount on Bonds Payable Cash 4. or factors that were carried out to more decimal places. This correlation between the interest expense and the bond’s book value makes the effective interest rate method the preferred method for amortizing the discount on bonds payable. 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. This calculation uses the market interest rate at the time the bonds were issued: The market rate of 10% per year divided by two semiannual periods = 5% semiannually. In our example.839 339 4. a financial calculator. including the entry to record the bond issuance. 2010 Dec 31. are shown next.000 4. The entries for 2010. the amortization of the bond discount can be recorded on the interest payment dates by using the amounts from the schedule above. Column C shows the interest expense. 2011 .807 307 4.

459 $ 99.000 of interest payments plus the $3.149 $ 96. Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases.770 $ 9.770 $ 9.239 $ 99. but allows the straight-line method when the amount of bond discount is not significant. .770 $ 9.766 $ 9. The accounting profession prefers the effective interest rate method. Comparison of Amortization Methods Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method.149 $ 96.629 $ 9.851 $ 96.919 $ 97.689 $ 98.778 $ 97.229 Year 2010 2011 2012 2013 2014 Totals Notice that under both methods of amortization.084 Straight-Line Method Interest Book Value at Expense Beg. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing.851 of bond discount. Effective Interest Rate Method Interest Expense $ 9. of Year $ 96.000. Also notice that under both methods the total interest expense over the life of the bonds is $48. the book value at the time the bonds were issued ($96.695 $ 9.851 is being reduced to $0 as the bond discount is amortized to interest expense.000 bond with a stated interest rate of 9% and maturing in 5 years.916 $ 48. The reason is that the bond discount of $3.845 $ 9.) Summary of the Effect of Market Interest Rates on a Bond’s Issue Price The following table summarizes the effect of the change in the market interest rate on an existing $100.The journal entries for the years 2012 through 2014 will also be taken from the schedule shown above.771 $ 48.149) moves toward the bond’s maturity value of $100.770 $ 9. of Year $ 9.473 $ 98.851 ($45.851 Book Value at Beg.

Bond’s Stated Interest Market Interest Issue Price of Bond Bond Issued At Rate per Year Rate per Year (Present Value) 9% 9% 9% 9% 8% 10% $100. Bonds allow corporations to use financial leverage or to trade on equity. These costs are referred to as issue costs. Bonds that mature on a single maturity date are known as term bonds. Convertible bonds allow the bondholder to exchange the bond for a specified number of shares of common stock. Many years ago corporate bonds could be unregistered. Some bonds require the issuing corporation to deposit money into an account that is restricted for the payment of the bonds’ maturity amount. they issue registered bonds. Instead. Most bonds are not convertible bonds. The restricted account is Bond Sinking Fund and it is reported in the long-term investment section of the balance sheet. Bonds that have specific assets pledged as collateral are secured bonds. . Over the life of the bonds the balance in the long term asset account Bond Issue Costs will be amortized to expense. Issue costs are likely to be recorded in the account Bond Issue Costs. A bond’s call price and other conditions can be found in a bond’s contract known as the indenture. and securities consultants. Such bonds were known as bearer bonds and the bonds had coupons attached that the bearer would “clip” and deposit at the bearer’s bank. An example of a secured bond would be a mortgage bond that has a lien on real estate. The call premium might be one year of additional interest. This account appears on the balance sheet under the heading of Other Assets or Deferred Charges. Bonds that do not have specific collateral and instead rely on the corporation’s general financial position are referred to as unsecured bonds or debentures.100 $ 96. corporations do not issue bearer bonds.149 Par Premium Discount Additional Bond Terminology Bonds are a form of long-term debt and might be referred to as a debt security.000 $104. Today. Callable bonds are bonds that give the issuing corporation the right to repurchase its bonds by paying the bondholders the bonds’ face amount plus an additional amount known as the call premium. Bonds that mature over a series of dates are serial bonds. These fees include payments to attorneys. The reason is that a corporation issuing bonds can control larger amounts of assets without increasing its common stock. accounting firms. There are various fees that a corporation must pay when issuing bonds.

. A basis point is 1/100th of one percentage point. For example.50%. the term basis point is often used. if a market interest rate increases from 6.25% to 6.When bond interest rates are discussed. the rate is said to have increased by 25 basis points.