Bond Issuance at a Discount
Record the issuance of bonds at a discount and prepare interest expense entries using the effective interest method. Understand why bonds sell at a discount.
Problem Scenario
On January 1, Year 1, Atlas Corporation issued $500,000 of 8% bonds (interest paid semiannually on June 30 and December 31) maturing in 5 years. The market interest rate at issuance was 10%. The bonds sold for $461,395.
Given Data
Requirements
- Record the bond issuance
- Record the first interest payment using effective interest method
- Record the second interest payment
- Explain why the bonds sold at a discount
Solution
Step 1:
Record bond issuance at discount:
| Account | Debit | Credit |
|---|---|---|
| Cash | $461,395 | |
| Discount on Bonds Payable | $38,605 | |
| Bonds Payable | $500,000 |
Step 2:
First interest payment (June 30, Year 1): Cash paid = $500,000 × 4% = $20,000. Interest expense = $461,395 × 5% = $23,070. Discount amortization = $23,070 - $20,000 = $3,070. New carrying value = $461,395 + $3,070 = $464,465.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | $23,070 | |
| Discount on Bonds Payable | $3,070 | |
| Cash | $20,000 |
Step 3:
Second interest payment (December 31, Year 1): Cash paid = $20,000. Interest expense = $464,465 × 5% = $23,223. Discount amortization = $23,223 - $20,000 = $3,223. New carrying value = $464,465 + $3,223 = $467,688.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | $23,223 | |
| Discount on Bonds Payable | $3,223 | |
| Cash | $20,000 |
Step 4:
Why bonds sold at discount: The stated rate (8%) is less than the market rate (10%). Investors demand the market rate, so they pay less than face value. The discount compensates investors for receiving below-market coupon payments.
Final Answer
The bonds were issued at $461,395 (discount of $38,605). Year 1 total interest expense = $23,070 + $23,223 = $46,293, while cash paid was only $40,000. The difference ($6,293) amortizes the discount.
Key Takeaways
- ✓Bonds sell at discount when stated rate < market rate
- ✓Discount is amortized over bond life, increasing interest expense
- ✓Effective interest method: Interest Expense = Carrying Value × Market Rate
- ✓Cash paid = Face Value × Stated Rate
- ✓Carrying value increases each period until it reaches face value at maturity
Common Errors to Avoid
- ✗Using the stated rate instead of market rate for interest expense
- ✗Forgetting that discount amortization increases carrying value
- ✗Calculating interest expense on face value instead of carrying value
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Common questions about this problem type
The difference between interest expense and cash paid represents amortization of the discount. This extra expense reflects the true cost of borrowing at the market rate, even though the coupon payment is based on the lower stated rate.
At maturity, the carrying value will equal face value ($500,000) because all the discount has been amortized. The company pays bondholders the full face value.