The corporation must continue to pay $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six months. Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable. In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000. Let’s examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond’s stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000. Let’s assume that on January 1, 2024 a corporation issues a 9% $100,000 bond at its face amount.

Why are Bonds Issued?

When the market rate of interest is higher than the stated bond rate, the price of the bond must be lowered to equal the difference. This drop in price is referred to as the bond discount. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.

Company A issued bonds with a face value of $1,000,000. The investors paid only $900,000 for these bonds in order to earn a higher effective interest rate. Company A recorded the bond sale in its accounting records by increasing Cash in Bank (debit asset), Bonds Payable (credit liability) and the Discount on Bonds Payable (debit contra-liability).

Account

Some bonds require the issuing corporation to deposit money into an account that is restricted for the payment of the bonds’ maturity amount. The restricted account is Bond Sinking Fund and it is reported in the long-term investment section of the balance sheet. Use the semiannual market interest rate (i) and the number of semiannual periods (n) that were used to calculate the present value of the interest payments. In our example, there will be a $100,000 is discount on bonds payable an asset principal payment on the bond’s maturity date at the end of the 10th semiannual period.

• Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000.
• To illustrate the premium on bonds payable, let’s assume that a corporation prepares to issue bonds with a maturity amount of $10,000,000 and a stated interest rate of 6%.
• In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.

Can Companies Issue Stock to Pay Debt?

• However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year).
• The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate.
• The corporation is also required to pay $100,000 of principal to the bondholders on the bond’s maturity date of December 31, 2028.
• The account Premium on Bonds Payable is a liability account that will always appear on the balance sheet with the account Bonds Payable.
• You should consider our materials to be an introduction to selected accounting and bookkeeping topics (with complexities likely omitted).

Rather than adjusting the face value, the reduced interest to be paid is added to the cash. For the purposes of our example, we’ll say the bond sells at the discounted amount of $96,406. Rather than adjusting the face value, the additional interest to be paid is subtracted from the cash.

Next, let’s assume that after the bond had been sold to investors, the market interest rate increased to 10%. The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months. However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year).

Is Account Payable an Asset or a Liability?

Many bonds make payments to bondholders known as coupon or interest payments. These are typically made either annually or semiannually and are calculated as the percentage of the bond’s par value. If the bond sells at a premium or discount, three accounts are affected.To record the sale of a $1000 bond that sells at a premium for $1080, for example, debit Cash for $1080. Then, Credit Bonds Payable for $1000 and Premium on Bonds Payable (a liability account) for $80. Let’s modify our example so that the prevailing market rate is 10 percent and the bond’s sale proceeds are $961,500, which you debit to cash at issuance. When it is time to redeem the bonds, all premiums and discounts should have been amortized, so the entry is simply a debit to the bonds payable account and a credit to the cash account.

To illustrate the premium on bonds payable, let’s assume that a corporation prepares to issue bonds with a maturity amount of $10,000,000 and a stated interest rate of 6%. However, when the 6% bonds are actually sold, the market interest rate is 5.9%. The entry to record the issuance of the bonds increases cash for the $11,246 received, increases bonds payable for the $10,000 maturity amount, and increases premium on bonds payable for $1,246. Premium on bonds payable is a contra account to bonds payable that increases its value and is added to bonds payable in the long‐term liability section of the balance sheet. A discount on bonds payable occurs when bonds are issued for less than their face value. This happens when the stated interest rate on the bond is lower than the prevailing market interest rate.

If the bond has been sold at face value, rather at a premium or discount, the entry made is very simple. Amortize discounts or premiums in interest payment entries. Interest paid to bondholders is recorded as an inflow of cash. The accounting entries made are a debit to Cash and a credit to Interest Income, both for the amount of the coupon payment. When we issue a bond at a premium, we are selling the bond for more than it is worth.

Just make sure whether your teacher is going to focus on straight line, effective interest method, or both. But for now, let’s focus on the straight line method, just so you can kind of see how this works. And a lot of the principles between straight line and effective are very similar. So let’s go ahead and dive into this interest expense entry.

Premium on Bonds Payable with Straight-Line Amortization

Accounts payable is a liability, not an asset, as it represents outstanding payments a company owes to suppliers. Managing AP efficiently is crucial for maintaining cash flow, supplier relationships, and financial stability. Businesses can leverage accounts payable automation tools to optimize processes and reduce errors.

Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. It is reasonable that a bond promising to pay 9% interest will sell for less than its face value when the market is expecting to earn 10% interest.

Liabilities often have the word “payable” in the account title. Liabilities also include amounts received in advance for a future sale or for a future service to be performed. Bonds that do not have specific collateral and instead rely on the corporation’s general financial position are referred to as unsecured bonds or debentures. Bonds that mature on a single maturity date are known as term bonds. Bonds that mature over a series of dates are serial bonds. The bond’s total present value of $104,100 should approximate the bond’s market value.

Relationship Between Market Interest Rates and a Bond’s Market Value

First, calculate the bond’s market price by adding the current values of the interest payments to the principal. Then, subtract the face value from the market price you just worked out. Such discounts occur when the interest rate stated on a bond is below the market rate of interest and the investors consequently earn a higher effective interest rate than the stated interest rate. Obviously, on January 1st, 2019, so the next day, we’re going to make an entry to debit interest payable and credit cash, right? Because we’re actually going to make that payment and that’s going to be in the amount of $2,250, getting rid of the liability for interest payable.

For example, if a bond has a face value of $50,000 with a stated interest rate of 9%, but the market rate is 10%, the bond will sell at a discount. The discount represents the difference between the bond’s face value and its selling price. This discount is amortized over the life of the bond, increasing the bond’s carrying value until it reaches its face value at maturity. This account is amortized over the life of the bond using methods such as the straight-line or effective interest method. To illustrate the premium on bonds payable, let’s assume that in early December 2023, a corporation has prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). The bond is dated as of January 1, 2024 and has a maturity date of December 31, 2028.