Discount on Bonds Payable

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Discount on Bonds Payable?

Discount bonds payable are the bonds issued at a discount by the companies and happen when the coupon rate 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 entity’s bonds because it will bring a lower return on his investment compared to the market. Further,  in such a scenario, the entity will face challenges raising money through bonds.

Thus, to match the return of its bonds with the market, the issuing entity will lower the bond’s issue price. A US $ 1000 bond will be issued for 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 a 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 appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more for the investor as he is getting repaid the face value amount resulting in capital gain in his hand.

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Source: Discount on Bonds Payable (wallstreetmojo.com)

Pricing of a Discount Bond

To determine how much discount the company should offer while issuing its bond, the concept of the TVMTVMThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more is applied. Accordingly, the issue price of a bondPrice Of A BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more is the total present value of all coupon payments and the current value of the redemption amount.

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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, the prevailing market interest rate was 6% at the time of the issue. 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 valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more (PV) (PV) of coupon payments and maturity amount. The bond’s present value is calculated by discounting the coupon amount and maturity amount with a rate of return of similar bonds in the market. This rate is also known as Yield to MaturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more (YTM).

In our example, the YTM rate will be 6% p.a. It is the prevailing market interest rate on a similar trading bond.

Solution:

PV of Coupon Payment = (Face Value * Coupon Rate) * PV Discount Factor @ Discount Rate
  • 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  = (Face Value ) * PV Discount Factor @ Discount Rate for Year of Maturity.
Bond Price = PV of Coupon Payment + PV of Maturity Value.
  • 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 payableBonds PayableBonds payable are the company's long-term debt with the promise to pay the interest due and principal at the specified time as decided between the parties. A bond payable account is credited in the books of accounts with the corresponding debit to the cash account on the issue date.read more in the books of XYZ Inc.

  1. 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:
ParticularsDebitCredit
Bank A/C$957.88
Discount on Bonds Payable A/C $42.12
To Bondholders A/C$1,000
(Bond issued at a discount of US $42.12)
  1. 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:
ParticularsDebitCredit
Interest on Bonds A/C$58.42
To Discount on Bonds Payable A/C$8.42
To Bank A/C$50.00
Coupon payments charged as an expense and discount amortized

This will increase the interest expenseThe Interest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more to make it equal to the effective rate of return to the bondholder.

  1. At the end of the bond’s life, the following entry will be passed as the redemption of the bonds.
ParticularsDebitCredit
Bondholders A/C$1,000
To Bank A/C$1,000
Bonds Redeemed at par

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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of the issuer as an expense and amortized during the life of the bond.

This has been a guide to discounts on bonds payable. Here we discuss a discount on bonds payable journal entry and its bond pricing and constituents. You can learn more about accounting from the following articles –

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