Ch14 Long Term Liabilities Handout-2 Discounts

1 Discounts
When the market rate is greater than the contract rate of the bond, the result is a discount. A discount means the bond
will sell for less than 100.
Effects of a Discount: - Reduces the cash received by the company
- Increases the bond interest expense
Treatment in Balance Sheet:
Example: P1 million bond sold at 90
Bonds Payable 1,000,000
Less: Discount on Bonds Payable (100,000)
Carrying Value 900,000

1.1 Basic Journal Entries

Example: P1 million bond sold at 90
BOND ISSUANCE
ISSUERS POV BUYERS POV
Dr. Cash 900,000 Dr. Investment in Bonds 900,000
Dr. Discount on Bonds 100,000 Cr. Cash 900,000
Cr. Bonds Payable 1,000,000
(Please note this difference. In all other entries, the buyers POV is simply reversed. In this case, the buyers investment
in bonds is always at the carrying value)

1.2 Amortization
The discount is considered an extra interest expense. Therefore it must be distributed across the life of the bond.
The two methods we will discuss are the straight line method and the effective interest method.
Bond Interest Paid refers to the amount of interest to be paid in cash (Face Value X Coupon rate / Number of
Payments per Year)
Bond Interest Expense refers to the total amount of bond interest, which must include the discount. Bond
Interest Paid + Discount.

How to Compute:
Example: P1 million bond sold at 90. Interest payment is twice a year for 4 years at 5%.
Eight Interest Payments (25,000 X 8) 200,000 (Bond Interest Paid)
Plus: Discount 100,000
Bond Interest Expense 300,000 (This is for the entire 4 years)
Or

Principal 1,000,000
Plus: Interest Payments 200,000
Less: Proceeds from Bond Sale (900,000)
Bond Interest Expense 300,000

This means that a total of 200,000 in interest paid and 100,000 in discounts must be distributed or amortized
across the eight payment periods.

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Ch14 Long Term Liabilities Handout-2 Discounts
1.2.1 Straight Line Method
The amount of bond interest paid and the amount of discount amortized across each period is constant.
Computation:
Total Interest Expense / Number of Periods = Interest Expense per Period

Using the same example above:

300,000 / 8 periods = 37,500
Out of bond interest of 37,200 per 6 months, 25,000 will be the bond interest paid and 12,500 will be the amortized
discount every 6 months.

Amortization Table: Straight Line Method

A B C D E
Period Cash Interest Paid Interest Expense Discount Amortized Unamortized Discount Carrying Value
Beg.
1
2
3
4
5
6
7
8
*Each period = 6 months
A = Face Value x Coupon Rate / Number of Payments per Year
B = Total Interest Expense / Number of Periods
C=BA
D = Updated amount of discount remaining
E = Face Value D

Recording Interest Payment:

ISSUERS POV
Dr. Bond Interest Expense 37,500
Cr. Cash 25,000
Cr. Discount on Bonds 12,500
(Discount is originally a debit entry, that means this entry decreases the discount, and increases the carrying value. We
are distributing the discount as expense by P12,500 per period)

BUYERS POV
Dr. Cash 25,000
Dr. Investment in Bonds 12,500
Bond Interest Revenue 37,500
(This increases the Investment In Bonds account of the buyer. The carrying value for the issuer and the buyer should be
the same)

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Ch14 Long Term Liabilities Handout-2 Discounts
If Interest Payment occurs in between two periods:
Recognized accrued interest for both the cash to be paid and the discount

Example: The company pays interest every Nov 1 and May 1. The company adjusts its books every Dec 31.
ISSUERS POV BUYERS POV
Dec31 Dr. Bond interest expense (37,500x 2/6) 12,500 Dr. Interest receivable 8,333
Cr. Discount on bonds (12,500x 2/6) 4,167 Dr. Investment in bonds 4,167
Cr. Interest payable (25,000x 2/6) 8,333 Interest revenue 12,500
May1 Dr. Interest payable 8,333 Dr. Investment in bonds 8,333
Dr. Interest expense (37,500x 4/6) 25,000 Dr. Cash 25,000
Cr. Cash 25,000 Cr. Interest revenue 25,000
Cr. Discount on bonds (12,500x4/6) 8,333 Cr. Interest receivable 8,333

1.2.2 Effective Interest Method

Allocates interest expense such that the interest yields a constant rate, which is called the Effective Interest Rate.
The best method for computation is using an amortization table. Because of the long process, usually you will only
be asked to do up to 3 or 4 periods.

Example: A 10% P1,000,000, 3 year bond is issued on May 1 at 95.08. Interest is paid every May 1 and November 1.
Books are adjusted every December 31. The current market rate is 12%

Effective Interest Rate = 12% per annum or 6% every 6 months

A B C D E
Period Cash Interest Paid Interest Expense Discount Amortized Unamortized Discount Carrying Value
Beg

*Due to rounding error, we are left with a small amount of unamortized discount but this should be very close to zero.
*For the last period, we will solve for the amortized discount manually, to ensure that discount is fully amortized.

A = Face Value x Coupon Rate / Number of Payments per Year

B = Carrying Value x Market Rate / Number of Payments per Year (in this case 950,800 X .06 for the first period)
C=BA
D = Updated amount of discount remaining
E = Face Value D

The journal entries are the same as the straight line method. The only change will be in the amount of interest expense
and discount amortized.

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