Going About Issuing Bonds at a Discount

Issuing Bonds at a Discount

P2 Compute and record amortization of bond discount.

A discount on bonds payableDifference between a bond’s par value and its lower issue price or carrying value; occurs when the contract rate is less than the market rate. occurs when a company issues bonds with a contract rate less than the market rate. This means that the issue price is less than par value. To illustrate, assume that Fila announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate (paid semiannually), and a two-year life. Also assume that the market rate for Fila bonds is 10%. These bonds then will sell at a discount since the contract rate is less than the market rate. The exact issue price for these bonds is stated as 96.454 (implying 96.454% of par value, or $96,454); we show how to compute this issue price later in the chapter. These bonds obligate the issuer to pay two separate types of future cash flows:

1. Par value of $100,000 cash at the end of the bonds’ two-year life.
2. Cash interest payments of $4,000 (4% × $100,000) at the end of each semiannual period during the bonds’ two-year life.

Point: The difference between the contract rate and the market rate of interest on a new bond issue is usually a fraction of a percent. We use a difference of 2% to emphasize the effects.

The exact pattern of cash flows for the Fila bonds is shown in Exhibit 14.4.

EXHIBIT 14.4 Cash Flows for Fila Bonds

When Fila accepts $96,454 cash for its bonds on the issue date of December 31, 2011, it records the sale as follows.




These bonds are reported in the long-term liability section of the issuer’s December 31, 2011, balance sheet as shown in Exhibit 14.5. A discount is deducted from the par value of bonds to yield the carrying (book) value of bondsNet amount at which bonds are reported on the balance sheet; equals the par value of the bonds less any unamortized discount or plus any unamortized premium; also called carrying amount or book value.. Discount on Bonds Payable is a contra liability account.

EXHIBIT 14.5 Balance Sheet Presentation of Bond Discount

Point: Book value at issuance always equals the issuer’s cash borrowed.

Amortizing a Bond Discount
Fila receives $96,454 for its bonds; in return it must pay bondholders $100,000 after two years (plus semiannual interest payments). The $3,546 discount is paid to bondholders at maturity and is part of the cost of using the $96,454 for two years. The upper portion of panel A in Exhibit 14.6 shows that total bond interest expense of $19,546 is the difference between the total amount repaid to bondholders ($116,000) and the amount borrowed from bondholders ($96,454). Alternatively, we can compute total bond interest expense as the sum of the four interest payments and the bond discount. This alternative computation is shown in the lower portion of panel A.

Point: Zero-coupon bonds do not pay periodic interest (contract rate is zero). These bonds always sell at a discount because their 0% contract rate is always below the market rate.

The total $19,546 bond interest expense must be allocated across the four semiannual periods in the bonds’ life, and the bonds’ carrying value must be updated at each balance sheet date. This is accomplished using the straight-line method (or the effective interest method in Appendix 14B). Both methods systematically reduce the bond discount to zero over the two-year life. This process is called amortizing a bond discount.

Straight-Line Method
The straight-line bond amortization Method allocating an equal amount of bond interest expense to each period of the bond life. method allocates an equal portion of the total bond interest expense to each interest period. To apply the straight-line method to Fila’s bonds, we divide the total bond interest expense of $19,546 by 4 (the number of semiannual periods in the bonds’ life). This gives a bond interest expense of $4,887 per period, which is $4,886.5 rounded to the nearest dollar per period (all computations, including those for assignments, are rounded to the nearest whole dollar). Alternatively, we can find this number by first dividing the $3,546 discount by 4, which yields the $887 amount of discount to be amortized each interest period. When the $887 is added to the $4,000 cash payment, the bond interest expense for each period is $4,887. Panel B of Exhibit 14.6 shows how the issuer records bond interest expense and updates the balance of the bond liability account at the end of each of the four semiannual interest periods (June 30, 2012, through December 31, 2013).
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EXHIBIT 14.6 Interest Computation and Entry for Bonds Issued at a Discount

Exhibit 14.7 shows the pattern of decreases in the Discount on Bonds Payable account and the pattern of increases in the bonds’ carrying value. The following points summarize the discount bonds’ straight-line amortization:

EXHIBIT 14.7 Straight-Line Amortization of Bond Discount * Total bond discount (of $3,546) less accumulated periodic amortization ($887 per semiannual interest period). † Bond par value (of $100,000) less unamortized discount. ‡ Adjusted for rounding.

1. At issuance, the $100,000 par value consists of the $96,454 cash received by the issuer plus the $3,546 discount.
2. During the bonds’ life, the (unamortized) discount decreases each period by the $887 amortization ($3,546/4), and the carrying value (par value less unamortized discount) increases each period by $887.
3. At maturity, the unamortized discount equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder.

We see that the issuer incurs a $4,887 bond interest expense each period but pays only $4,000 cash. The $887 unpaid portion of this expense is added to the bonds’ carrying value. (The total $3,546 unamortized discount is “paid” when the bonds mature; $100,000 is paid at maturity but only $96,454 was received at issuance.)

Decision Insight

Ratings Game Many bond buyers rely on rating services to assess bond risk. The best known are Standard & Poor’s, Moody’s, and Fitch. These services focus on the issuer’s financial statements and other factors in setting ratings. Standard & Poor’s ratings, from best quality to default, are AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Ratings can include a plus (+) or minus (−) to show relative standing within a category. ▪