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 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. 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 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. 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. is the total of present values of all coupon payments and the current value of the redemption amount.
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 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. (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 MaturityYield To MaturityYield 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 expected returns after making all the payments on time throughout the life of a bond. (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.
- 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:
|Discount on Bonds Payable A/C||$42.12|
|To Bondholders A/C||$1,000|
- 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:
|Interest on Bonds A/C||$58.42|
|To Discount on Bonds Payable A/C||$8.42|
|To Bank A/C||$50.00|
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.
|To Bank A/C||$1,000|
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. of the issuer as an expense and amortized during the life of the bond.
This has been a guide to discount on bonds payable. Here we discuss a discount on bonds payable journal entry along with its bond pricing and constituents You can learn more about accounting from the following articles –