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.
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
FAQs
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.
Straight-line amortizes the same dollar amount of discount each period ($38,605 / 10 = $3,861 per period). Effective interest applies the market rate to the current carrying value, producing increasing amortization amounts as carrying value grows. GAAP prefers the effective interest method because it maintains a constant effective interest rate each period.
Because the carrying value increases as the discount is amortized, and interest expense equals carrying value times the market rate. Higher carrying value = higher interest expense. Period 1: $461,395 × 5% = $23,070. Period 2: $464,465 × 5% = $23,223. This continues until carrying value reaches $500,000 at maturity.