Journal entry for issuing bonds at discount

Introduction

In business, we may issue bonds at a discount when the interest rate on our bonds is below the current market interest rate. In this case, we need to make the journal entry for issuing bonds at discount by recognizing and recording the difference between the cash received and the face value of the bond as the bond discount or the discount on bonds payable.

In accounting, the bond discount or the discount on bonds payable is considered a borrowing cost in addition to the contractual interest of the bond. And this additional borrowing cost will need to be recognized and recorded in the income statement as an expense with the amortization in each accounting period throughout the maturity of the bond. Likewise, the interest expense from the issuance of the bonds at discount will be higher than the contractual interest in the bond.

We may amortize the discount on bonds payable by using the straight-line method or the effective interest rate method. However, if the amount is significant or material to the financial statements, we are usually required to use the effective interest rate method to amortize the discount amount in each accounting period.

Journal entry for issuing bonds at discount

We can make the journal entry for issuing bonds at discount by debiting the cash account and the discount on bonds payable account and crediting the bonds payable account.

In this journal entry, the discount on bonds payable is a contra account to the bonds payable in which its normal balance is on the debit side. Likewise, this account will be classified in the liability section of the balance sheet.

The balance of the discount on bonds payable account will be transferred to the interest expense through the amortization in each accounting period and it will become zero at the end of the bond maturity.

On the other hand, the bonds payable will be recorded at their face value which is more than the amount of the cash we receive at the date of issuing the bonds at discount.

Issuing bonds at discount example

For example, on January 1, 2022, we issue five-year, 7% bonds at discount for $96,007. The bonds have a face value of $100,000. And the interest on bonds will be payable annually on December 31.

Our year-end for the accounting period is at December 31 and the market interest rate is 8% per annum. In order to comply with the company’s policy and the accounting rule, we are required to amortize the bond discount with an effective interest rate method.

What is the journal entry for issuing bonds at discount on January 1 and the interest payment and amortization of the discount on December 31?

Solution:

Issuing bonds at discount on January 1

As we issue the bonds at discount, we can record the difference between the amount we receive and the face value of the bond as the discount on bonds payable. In the above example, the difference is $3,993 ($100,000 – $96,007).

Likewise, we can make the journal entry for issuing bonds at discount on January 1 as below:

In this journal entry, the $3,993 discount of bonds payable will be net off with the bonds payable account when we determine the total liabilities on the balance sheet. Likewise, both total assets and total liabilities on the balance sheet increase by $96,007 as of January 1.

Interest and amortization of the discount on December 31

As we amortize the discount on bonds payable using the effective interest rate method, we need to determine the net book value of the bonds payable on January 1 (beginning of accounting period), then use it to multiply with the market interest rate of 8% to get the total interest expense for 2022. Then we can compare the result with the contractual interest to determine the difference which will be the amortized portion of the discount on bonds payable for 2022.

In this case,

Net book value of bonds payable on January 1 = $100,000 – $3,993 = $96,007

Total interest expense for 2022 = $96,007 x 8% = $7,681

Amortized discount on bons payable in 2022 = $7,681 – $7,000 = $681

*The $7,000 is the interest that we need to pay on December 31. It comes from the face value of the bond multiplying the contractual interest rate ($100,000 x 7%).

Likewise, we can make the journal entry for the interest payment and amortization of the discount on bonds payable on December 31 as below:

Amortization of the discount on bonds payable:

Interest payment:

After this journal entry, the balance in the discount on bonds payable account will be reduced from $3,993 to $3,312 ($3,993 – $681) as of December 31, 2022, and it will be reduced further to zero at the end of the bond maturity as in the table below:

Amortization of the discount on bonds payable

As mentioned, we should amortize the discount on bonds payable using the effective interest rate method if the amount is material or significant to the financial statements. However, if it is not the case, we may use either the straight-line method or the effective interest rate method for the amortization of the discount on bonds payable.

Straight-line method

We can amortize the discount on bonds payable with the straight-line method by dividing the discount amount by the maturity period of the bond. The straight-line method of amortization will result in an equal amount of amortized portion of the bond discount in each period through the bond maturity.

For example, if we use the straight-line method in the example above instead, we can amortize the $3,993 discount on bonds payable by dividing it by the 5 years period of the bond maturity. This will result in an amortized discount of $799 ($3,993 / 5) each year throughout the maturity of the bond.

Likewise, if we use the straight-line method for the amortization of discount on bonds payable in the example above, we can get the amortization table as below instead:

In this case, the journal entry for amortization of the discount on bonds payable on December 31, 2022, would change to be as below instead:

Effective interest rate method

We can amortize the discount on bonds payable using the effective interest rate method by multiplying the net book value of the bonds payable at the beginning of the period with the market interest rate. Then using the result to compare with the contractual interest on the bond during the period. The difference is the amortized portion of the discount during the period.

Unlike the straight-line method, the amortized portion of the discount in one period will be different from another period. And this amount will increase from one period to the next as the net book value of the bonds payable increases (because of the decrease of its contra account which is the discount on bonds payable).

As in the example of issuing bonds at the discount above, we calculate the amortization of the discount on bonds payable by using the net book value of $96,007 ($100,000 – $3,993) to multiply with 8% of the market interest rate to get the $7,681.

Then we compare the $7,681 to the contractual interest of $7,000 which gives a result of the $681 difference which is an amortized portion of the discount on bonds payable for the accounting period of 2022.

If we compare the effective interest rate method and the straight-line method of amortization using the example above, we can see the difference between the two in each period as in the table below: