What is Discount on Bonds Payable?
Discount bonds payable are the bonds issued at discount by the companies and happens when the coupon rate that if offers is less than the prevailing market interest rate. Such bonds trade at a price less than their face value.
How does It work?
If the company issues the bond at a coupon rate, which is less than the market interest rate, the investor won’t buy the bonds of the entity because it will bring a lower return on his investment as compared to the market. Further, in such a scenario, the entity will face challenges in raising money through bonds.
Thus, to match the return of its bonds with the market, the issuing entity will lower the issue price of the bond. Let’s say a US $ 1000 bond will be issued for the US $ 950. It means the investor will pay the issue price of US $ 950 to the entity to buy a bond, and in return, he will earn coupon amount on face value, and at the time of maturity, he will receive the face value amount of US $ 1000 as maturity value.
This transaction will result in the capital appreciation for the investor as he is getting repaid the face value amount resulting in capital gain in his hand.
Pricing of a Discount Bond
To determine how much discount the company should offer while issuing its bond, the concept of the TVM is applied. Accordingly, the issue price of a bond is the total of present values of all coupon payments and the current value of the redemption amount.
Example
For instance, let us assume ABC Inc. is planning to raise funds through the issue of a 5-year bond, having a par value of US $ 1000 at a coupon rate of 5%p.a. However, at the time of issue, the prevailing market interest rate was 6%. Now, the company has to issue its bond at a discount to compensate for the return on investment of the bondholders.
In this case, the entity will determine its issue price by calculating the present value (PV) of coupon payments and maturity amount. The present value of the bond is calculated by discounting the coupon amount, and maturity amount with a rate of return of similar bonds in the market, and this rate is also known as Yield to Maturity (YTM).
In our example, the YTM rate will be 6% p.a. as it is the prevailing market interest rate on a similar trading bond.
Solution:
- PV of the coupon payment = ($ 1000 * 5%)*(1/(1+6%)1) + ($ 1000 * 5%)*(1/(1+6%)2) + ($ 1000 * 5%)*(1/(1+6%)2) + ($ 1000 * 5%)*(1/(1+6%)3) + ($ 1000 * 5%)*(1/(1+6%)4) + ($ 1000 * 5%)*(1/(1+6%)5)
- PV of the coupon payment = $ 210.62
- PV of Maturity Value = $ 1000 * (1/(1+6%)5)
- PV of Maturity Value = $ 1000 * 0.747258
- PV of Maturity Value = $ 747.26
- Bond Price = $ 210.26 + $ 747.26
- Bond Price = $ 957.88
Thus, XYZ Inc. will issue its bond at an issue price of US $ 957.88 to compensate for the return on investment of the bondholders.
Journal Entry of Discount on Bond Payable
Continuing with the above example, let’s understand the journal entry of discount on bonds payable in the books of XYZ Inc.
- On the issue of bonds at a discount the company will record the issue of bonds and record the loss on account of issuing at a discount with the following journal entry:
- At the end of each year, the entity will make coupon payments as well as amortize the discount on bonds by charging it to Interest Account as:
This will increase the interest expense to make it equal to the effective rate of return to the bondholder.
- At the end of the life of the bond, the following entry will be passed as the redemption of the bonds.
Conclusion
The discount on bonds generally arises when the bonds are issued at a coupon rate, which is less than the prevailing market interest rate (YTM) of the similar bonds. The discount should be charged to the income statement of the issuer as an expense and amortized during the life of the bond.
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