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Sale or Issuance of Bonds at a Discount in Financial Accounting

In cases where the coupon rate of interest differs from the market rate on the date that bonds are sold, the present value of the bond issue will not equal the face amount of the bond. Consider, for example, an investor buying a bond when the coupon rate is below the market rate of interest. Because the coupon rate does not provide the investor with a rate of return equal to that available on other similar investments, the investor will buy the bonds only if they are sold at a discount from the par or face value. Bear in mind that the bond contract represents a fixed series of cash paymentsto bondholders. The present value of any fixed series of cash payments depends on the discount rate, which in this case is the market rate of interest.

To illustrate the accounting for bonds sold at a discount, assume that the Marley Company bonds described earlier were sold on January 1, 2000, and that the market rate of interest was 16% (compounded semiannually) on that date. Investors will discount the bonds’cash flows at the current market rate of interest. Because the coupon rate is only 12%, the bonds will sell at a discount. Note, however, that the interest coupon payments will still be $6 million because that is the amount stated in the bond contract. The present value is computed as follows.

Principal, due in 20 six-month periods at 8% (half the 16% annual rate):

Interest payments, due each six months for 20 periods:

Consequently, the bonds will sell at $80,408,000 ($100 million face value, minus $19,592,000 discount), i.e., at a price of $80.408. If prospective bondholders were to deposit $80,408,000 in an account earning interest at 16% compounded semiannually, they would be able to withdraw $6 million each six months and $100 million at the end of 10 years. For this reason, bond investors would be unwilling to pay more than $80,408,000 for the Marley Company bonds.

Upon issuing the bonds, Marley Company’s cash and bonds payable (net of the bond discount) will increase by $80,408,000:

In effect, the discount represents additional interest paid to bondholders. This compensates for the fact that the coupon interest payments are lower than those provided by competing investments. The total interest expense is determined as follows:

The amount of this interest expense to be recognized each interest period (an interest period is six months in this example) is based on the reported value of the bonds at the start of the interest period and the market rate of interest when the bonds wereissued. Because Marley Company’s bonds were sold on January 1, 2000, when the market rate of interest was 16% compounded semiannually, or 8% each six-month period, the interest expense during 2000, 2001, and 2009 would be determined as shown in figure 8.1.

Figure 8.1 - Calculation of Interest Expense

NOTE: The reported value of the bonds increases each period because the interest expense exceeds the amount paid to the bondholders, which increases the company’s obligation to the bondholders. At the maturity date of the bonds, the reported value will equal the principal (face) amount of $100 million.

Whenever the periodic interest expense differs from the periodic cash payments to the bondholders, the reported value of the bonds will be adjusted for the difference. This adjustment is termed amortization. In figure 8.1, note that the interest expense recorded in each period exceeds the cash interest ($6,000,000) that is paid to the bondholders. Because the actual interest expense incurred each period is greater than the amount that is paid currently to the bondholders, the reported value of the bonds (bonds payable minus discount) increases each period. In fact, as shown in figure 8.1, the reported value of the bonds will increase to exactly $100,000,000, the principal amount of the bonds, by the date that the bond issue matures (at the end of the year 2009). In other words, the discount on the bonds will be completely amortized by that date, so the bonds will be reported at their face value of $100 million. The interest expense and bond coupon payment for the first six months in 2000 would be recorded in the following way:

As you can see, because the cash payment required by the coupon rate of interest is less than the actual interest expense for the period, the amount of the liability must be increased for the difference. During the first interest period (January 1 to June 30, 2000), $432,640 of the bond discount has been amortized.

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