The term bonds issued at a discount refers to newly issued debt that is sold at a price which is less than its par value. When a bond is issued at a discount, the company will typically choose to amortize the discount over the term of the bond using a straight line method.
Bonds can sell at a premium or discount to par value due to administrative delays in getting the offering to market.
Issuing long-term bonds represents an important source of financing for many companies. When a corporation prepares to issue bonds to investors, they determine an acceptable coupon rate, which reflects both the prevailing rate of interest and the creditworthiness of the company.
The process of issuing bonds to the public takes a considerable amount of time. Approval is needed from the Securities and Exchange Commission, a prospectus must be written, and underwriting of the securities might be arranged. This delay, along with changes in variables such as prevailing interest rates or the creditworthiness of the issuing company, can result in the bonds selling at a discount to their face value. As a general rule of thumb, the price of a bond will move inversely with interest rates.
If a bond is sold at a discount, the shortfall is referred to as a discount on bonds payable. Companies will typically choose to use a straight line method to amortize this discount over the term of the bond.
Company A issued $5,000,000 in bonds with a coupon rate of 4.0% and a term of fifteen years. The Federal Reserve increased interest rates slightly as Company A prepared the public offering of these securities. For this reason, the bonds were sold at 97, which is 97% of par value.
The journal entry to record the issuing of the bonds at a discount would be:
|Cash ($5,000,000 x 0.97)||$4,850,000|
|Discount on Bonds Payable||$150,000|
Using the straight line method, Company A would amortize the discount over a period of fifteen years. The journal entry for this transaction is as follows:
|Discount on Bonds Payable ($150,000 / 15 years)||$10,000|
As noted in the above journal entry, selling the bond at a discount effectively increases the interest expense of the issuing company.