Discount Bond: Definition, Using Yield to Maturity, and Risks

Bondholders receive only $6,000 every 6 months, whereas comparable investments yielding 14% are paying $7,000 every 6 months ($100,000 x .07). Based on this effective rate, the bonds would be issued at a price of 92.976, or $92,976. This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. If the discount amount is immaterial, the parent and contra accounts can be combined into a one balance sheet line-item. For those issuing the bond, amortization is an accounting tactic that has beneficial tax implications.

The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
Contingent convertibles (CoCos) have additional features based on capital adequacy ratios but come with event risk.
There are strategies that can be leveraged to optimize the tax efficiency of an investor’s bond portfolios, such as investing in tax-exempt bonds.
See Table 1 for interest expense calculated using the straight‐line method of amortization and carrying value calculations over the life of the bond.
The existence of the discount in the offering indicates there is some concern of the underlying company being able to pay dividends and return the principal on maturity.

The root cause of the bond discount is the bonds have a stated interest rate which is lower than the market interest rate for similar bonds. Company XYZ, a tech firm, issues $1,000,000 in 5-year bonds with a face value (par value) of $1,000 each. However, due to prevailing market interest rates being higher than the coupon rate they can offer, they issue these bonds at a discount. The coupon rate is set at 4%, but investors require a 6% yield on similar bonds in the market.

What is Bonds Payable?

If this happens, the issuer amortizes the excess payment over the life of the bond. The bonds have a term of five years, so that is the period over which ABC must amortize the discount. Company C issue 9%, 3 years bond when the market rate is only 8%, par value is $ 100,000.

The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold. The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized.

The bonds are issued when the prevailing market interest rate for such investments is 14%.
A basic rule of thumb suggests that investors should look to buy premium bonds when rates are low and discount bonds when rates are high.
The commercial paper involves fixed interest rates, which differs from the concept of the floating-rate bond.
Calculating bond prices involves evaluating coupon payments and present value factors and comparing them to the principal.

As investors are not currently invested in other such bonds that allow for higher interest payments, an opportunity cost exists in holding the lower interest-paying bonds. Therefore, the future values of any coupons or the bond’s interest rate are less valuable in high-interest rate environments. To calculate interest expense for the next semiannual 22 examples of business ideas for the finance sector payment, we subtract the amount of amortization from the bond’s carrying value and multiply the new carrying value by half the yield to maturity. To calculate interest expense for the next semiannual payment, we add the amount of amortization to the bond’s carrying value and multiply the new carrying value by half the yield to maturity.

Straight-Line Amortization of Bond Discount on Annual Financial Statements

As the company decides to buyback bonds before maturity, so the carrying amount is different from par value. We need to calculate the carrying amount and compare it with the purchase price to calculate gain or lose. The discount on Bonds Payable will be net off with Bonds Payble to show in the balance sheet.

Even bonds are issued at a premium or discounted, we need to calculate the carrying value and compare with the cash payment to calculate the gain or lose. At the end of the third year, premium bonds payable will be zero and the carrying amount of bonds payable will be $ 100,000. So the journal entry is debit bonds payable and credit cash paid to investors.

Pricing of bond payable

An opposing idea from serial bonds, sinking fund bonds involves the company doing the purposeful act of setting money aside in a fund to start bond buybacks. Now, we will go through various types of bonds that investors deal with that are payable through one of the three methods above. Keep in mind that for corporations to issue floaters(corporate floating rate notes or FRNs) is different from commercial paper. The commercial paper involves fixed interest rates, which differs from the concept of the floating-rate bond. GAAP requires that the discount is amortized into interest expense over time.

Amortizing Premiums and Discounts

At that point, the carrying value of the bond should equal the bond’s face value. If a bond is issued at a premium or at a discount, the amount will be amortized over the years through to its maturity. On issuance, a premium bond will create a “premium on bonds payable” balance. The actual interest paid out (also known as the coupon) will be higher than the expense.

Bond Payables

People invest in putable bonds to stave off the effects of interest rate hikes in the market. As analyzed in the next section, there is an inverse relationship between interest rate and bond pricing/value. However, CoCos are still meant and ranked higher in the capital structure against common equity. Multiple banks have assured that CoCos will be prioritized against common equity should the bank be limited in funds.

In this case, the term “bullet” refers explicitly to a 1-time lump sum repayment to the debtor from the issuer. Amortizing bonds are also callable (redeemable) by the debtor; hence if these bonds should be called, the investor would usually have to reinvest his money returned in other avenues at a lower interest rate. Counterparty risk, like the serial bonds outlined above, is low as a certain dollar of the final bond amount payable is reduced with every interest payment. The value of floating rate bonds sees their interest rates vary depending on the SOFR rate.

Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, issued on July 1 when the market interest rate is 10%. The entry to record the issuance of the bonds increases (debits) cash for the $9,377 received, increases (debits) discount on bonds payable for $623, and increases (credits) bonds payable for the $10,000 maturity amount. Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long‐term liability section of the balance sheet. Initially it is the difference between the cash received and the maturity value of the bond. On July 1, Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon rate of interest of 12% and semiannual interest payments payable on June 30 and December 31, when the market interest rate is 10%.

Distressed and Zero-Coupon Bonds

All other interest payments are only coupons based on the bond’s interest rate. It is worth remembering that the $6,000 annuity, which is the cash interest payment, is calculated on the actual semi-annual coupon rate of 6%. To illustrate the issuance of bonds at a discount, suppose that on 2 January 2020, Valenzuela Corporation issues $100,000, 5-year, 12% term bonds. Such discounts occur when the interest rate stated on a bond is below the market rate of interest and the investors consequently earn a higher effective interest rate than the stated interest rate.

These convertible bonds will dilute shareholders’ equity as well, so this is a consideration for investors buying the company’s common equity, along with investors of vanilla convertible bonds. From the investor’s perspective, sinking fund bonds could have the company repurchase its bonds at either the par price or the market price of the bonds, whichever is lower. However, the serial bonds for specific projects by the corporations have infrequent cash flow amounts, and the company has difficulties very early on in repayment of the percentage of face value by the maturity date. Along with the percentage of face value repaid with every maturity date reached, interest payments of a certain amount (dictated by the conditions of the bond determined before the debt is issued) will be paid out.

The difference of $200,000 will be recorded by the issuing corporation as a debit to Discount on Bonds Payable, a debit to Cash for $9,800,000, and a credit to Bonds Payable for $10,000,000. Discount on bonds payable occurs when a bond’s stated interest rate is less than the bond market’s interest rate. Understanding how to record and manage Discounts on Bonds Payable is vital for companies and organizations that issue bonds as a means of raising capital.

The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the terms discount on bonds payable, bond discount, or discount. As the premium is amortized, the balance in the premium account and the carrying value of the bond decreases. The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account. See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium. At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 .