A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. By doing so, investors earn a greater return on their reduced investment. If so, the issuing entity stores the amount of this discount (the difference between the face value and the amount paid) in a contra liability account, and amortizes the amount of this reduced payment over the term of the bonds, which increases the amount that the business records as interest expense. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold.
The concept is best described with the following example.
Example of the Amortization of a Bond Discount
ABC International issues $10,000,000 of bonds at an interest rate of 8%, which is somewhat lower than the market rate at the time of issuance. Accordingly, investors pay less than the face value of the bonds, which increases the effective interest rate that they receive. Thus, ABC does not receive the face value of $10,000,000 for the bonds, but rather $9,900,000, which is a discount from the face value of the bonds.
ABC records the initial receipt of cash with this entry:
|Discount on bonds payable||100,000|
If ABC were to report the sale of bonds on its balance sheet immediately after the bond issuance, the bonds payable account and the discount on bonds payable account would be netted together, so that the total amount of the bond presented would be $9,900,000.
ABC must then reduce the $100,000 discount on its bonds payable by a small amount during each of the accounting periods over which the bonds are outstanding, until the balance in the discount on bonds payable account is zero when the company has to pay back the investors. The bonds have a term of five years, so that is the period over which ABC must amortize the discount.
There are two ways for ABC to amortize the discount. Since the discount is so small, it can amortize the amount on a straight-line basis, and simply debit $20,000 to interest expense in each successive year, with the following entry:
|Discount on bonds payable||20,000|
The amount is a debit to interest expense, since it represents an increase of the stated interest rate of 8% on the bonds; this is the case because investors paid less than the face value of the bonds, so the effective interest rate to the company is higher than 8%.
As the balance in the discount on bonds payable account declines over time, this means that the net amount of the bonds payable account and discount on bonds payable account presented in the balance sheet will gradually increase, until it is $10,000,000 as of the date when the bonds are to be repaid to investors.
The second way to amortize the discount is with the effective interest method. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period. This method is required for the amortization of larger discounts, since using the straight-line method would materially skew a company's results to recognize too little interest expense in the early years and too much expense in later years.
The format of the journal entry for amortization of the bond discount is the same under either method of amortization - only the amounts recorded in each period will change.
Discount amortizations are likely to be reviewed by a company's auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision.