What impact will the amortization of a bond discount have on reported interest expense?

Learning Outcomes

• Record the entries for a bond issue sold at a discount and sold at a premium, using the straight-line amortization method

Bonds Issued at a Discount

When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable. This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment.

Watch It: Bonds Issued at a Discount

Here is a video example and then we will do our own example:

You can view the transcript for “Issuing Bonds at a Discount” here (opens in new window).

Bonds Issued at a Discount Example: Carr

Assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 95 1/2 or 95.50% with interest to be paid semi-annually on June 30 and December 30 for cash. We know this is a discount because the price is less than 100%. The entry to record the issue of the bond on January 1 would be:

When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. The bond pays interest every 6 months on June 30 and December 31. We will amortize the discount using the straight-line method meaning we will take the total amount of the discount and divide by the total number of interest payments. In this example, the discount amortization will be $4,500 discount amount / 6 interest payment (3 years × 2 interest payments each year). The entry to record the semi-annual interest payment and discount amortization would be:

At maturity, we would have completely amortized or removed the discount so the balance in the discount account would be zero. Our entry at maturity would be:

Bonds Issued at a Premium

When we issue a bond at a premium, we are selling the bond for more than it is worth. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable. Just like with a discount, the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual interest payment.

Watch It: Bonds issued at a premium

Here is a video example and then we will do our own example:

You can view the transcript for “Issuing Bonds at a Premium” here (opens in new window).

Bonds Issued at a Premium Example: Carr

Assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 105 1/4 or 105.25% with interest to be paid semi-annually on June 30 and December 31 for cash. We know this is a discount because the price is less than 100%. The entry to record the issue of the bond on January 1 would be:

Remember, when a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. A premium decreases the amount of interest expense we record semi-annually. In our example, the bond pays interest every 6 months on June 30 and December 31. We will amortize the premium using the straight line method meaning we will take the total amount of the premium and divide by the total number of interest payments. In this example, the premium amortization will be $5,250 discount amount / 6 interest payment (3 years × 2 interest payments each year). The entry to record the semi-annual interest payment and discount amortization would be:

Just like with a discount, we would have completely amortized or removed the premium so the balance in the premium account would be zero. Our entry at maturity would be:

Bonds Issued at Face Value between Interest Dates

Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check.

Using facts for Valley bonds dated 2010 December 31, suppose Valley issued its bonds on May 31, instead of on December 31. The entry required is:

This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.

The entry required on June 30, when the full six months’ interest is paid, is:

This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.

PRACTICE QUESTION

How does the amortization of the bond discount affect the interest expense for a period?

What impact will the amortization of a bond premium have on reported interest expense?

What is the effect of amortizing bond premium and bond discount on interest income?

Will the amortization of discount on bonds payable increase or decrease bond interest expense?