When bonds are issued at a premium or discount, the difference between cash interest (stated rate) and interest expense/revenue (market rate) must be recognised through amortisation over the bond's life. GAAP prefers the effective interest method, which multiplies the outstanding carrying value by the market rate each period. This part also covers journal entries for issuance, accrued interest between payment dates, debt issue costs, early extinguishment, convertible bonds, and balance sheet presentation.
Difficulty: Intermediate to Advanced. Prerequisites: Part 1 of these notes (bond pricing, par/premium/discount concepts), present value tables, and basic debit/credit journal entry mechanics.
Once a bond is issued, the accounting work begins. This section covers how issuers and investors record bonds on their books, how the premium or discount is systematically eliminated over the bond's life, and what happens when bonds are sold early, called, or converted into stock. These mechanics determine what appears on both the balance sheet (carrying value of the liability or investment) and the income statement (interest expense or revenue). If Part 1 was about "what price does the bond sell for?", Part 2 is about "what do we do with that price for the next 5, 10, or 30 years?"
Valuation account
The premium or discount account that adjusts the face value of bonds to their carrying value on the balance sheet. Think of it as the bridge between the bond's face amount and what it is currently worth on the books.
Amortisation (of premium or discount)
The gradual, systematic reduction of a bond premium or discount to zero over the bond's life, with each portion recognised as part of interest expense (issuer) or interest revenue (investor). In simple terms, it is the process of "using up" the premium or discount a little bit each period.
Effective interest method
The GAAP-preferred method for amortising premiums and discounts, where interest expense/revenue each period equals the carrying value times the market rate. Think of it as the method that gives you a different interest expense each period because the carrying value keeps changing.
Straight-line method
An alternative amortisation method that spreads the premium or discount evenly across all payment periods. In simple terms, you divide the total premium or discount by the number of periods and amortise the same amount each time. Allowed under GAAP only if results are not materially different from the effective interest method.
Debt issue costs
Legal, accounting, registration, and underwriting fees incurred to issue bonds. These are recorded as an asset and amortised to expense on a straight-line basis over the bond's life. Think of them as the transaction costs of borrowing.
Early extinguishment
The retirement of bonds before their maturity date, either by calling them or purchasing them on the open market. The difference between the carrying value and the cash paid is recorded as a gain or loss.
Convertible bonds
Bonds that give the bondholder the option to exchange them for shares of the issuer's common stock. In simple terms, investors get the safety of a bond with the upside option of becoming shareholders.
Book value method (for conversion)
The method of recording a bond conversion where the carrying value of the bonds becomes the value of the new shares issued, with no gain or loss recognised. Think of it as simply relabelling the liability as equity at whatever amount it stands.
Held-to-maturity (HTM)
An investment classification for debt securities the investor intends and is able to hold until maturity. HTM bonds are carried at amortised cost, not fair value, because temporary market fluctuations are irrelevant if you are holding to the end.
Amortised cost
Face value plus remaining premium, or minus remaining discount. This is the carrying value of an HTM bond investment, which changes each period as the premium or discount amortises but is not the same as fair value.
Using the $10,000, 5-year, 12% semi-annual bond from Part 1:
Issuer:
Dr. Cash 10,000
Cr. Bonds Payable 10,000
Investor:
Dr. Investment in Bonds 10,000
Cr. Cash 10,000
Issuer:
Dr. Cash 10,772
Cr. Bonds Payable 10,000
Cr. Premium on Bonds Payable 772
Investor:
Dr. Investment in Bonds 10,000
Dr. Premium on Bond Investment 772
Cr. Cash 10,772
Issuer:
Dr. Cash 7,542
Dr. Discount on Bonds Payable 2,458
Cr. Bonds Payable 10,000
Investor:
Dr. Investment in Bonds 10,000
Cr. Discount on Bond Investment 2,458
Cr. Cash 7,542
The face value is always recorded in the main account (Bonds Payable or Investment in Bonds)
The premium or discount goes into a separate valuation account
For the issuer: Bonds Payable (credit) minus Discount (debit) = carrying value at a discount; Bonds Payable (credit) plus Premium (credit) = carrying value at a premium
For the investor: Investment (debit) minus Discount (credit) = carrying value at a discount; Investment (debit) plus Premium (debit) = carrying value at a premium
At par (market rate 12%):
Issuer: Dr. Interest Expense 600, Cr. Cash 600
Investor: Dr. Cash 600, Cr. Interest Revenue 600
At a premium (market rate 10%):
Issuer: Dr. Interest Expense 539 (10,772 x 5%), Dr. Premium on BP 61, Cr. Cash 600
Investor: Dr. Cash 600, Cr. Interest Revenue 539, Cr. Premium on Bond Investment 61
Interest expense/revenue = carrying value x market rate per period. The difference between cash interest (600) and effective interest (539) is the premium amortisation (61).
At a discount (market rate 20%):
Issuer: Dr. Interest Expense 754 (7,542 x 10%), Cr. Discount on BP 154, Cr. Cash 600
Investor: Dr. Cash 600, Dr. Discount on Bond Investment 154, Cr. Interest Revenue 754
The difference between effective interest (754) and cash interest (600) is the discount amortisation (154).
Each period, interest expense (or revenue) is calculated as:
Effective interest = Outstanding balance (carrying value) x Market rate per period
The difference between this amount and the cash interest (face value x stated rate per period) is the amortisation of the premium or discount.
For the $10,000 bond at a premium (carrying value starts at $10,772, semi-annual market rate 5%):
Each period, effective interest is less than cash interest
The difference reduces the premium
Carrying value decreases toward $10,000 (face value) by maturity
Interest expense decreases slightly each period because the carrying value shrinks
Example from the schedule: Period 1 effective interest = $10,772 x 5% = $539. Cash interest = $600. Premium amortised = $61. New carrying value = $10,711.
For the $10,000 bond at a discount (carrying value starts at $7,542, semi-annual market rate 10%):
Each period, effective interest is greater than cash interest
The difference reduces the discount
Carrying value increases toward $10,000 (face value) by maturity
Interest expense increases slightly each period because the carrying value grows
Example from the schedule: Period 1 effective interest = $7,542 x 10% = $754. Cash interest = $600. Discount amortised = $154. New carrying value = $7,696.
When stated rate equals market rate, cash interest equals effective interest every period. The carrying value stays at $10,000 throughout. There is no premium or discount to amortise.
Premium: carrying value falls each period, interest expense falls each period
Discount: carrying value rises each period, interest expense rises each period
Both converge to face value at maturity, when the premium or discount is fully amortised to zero
The straight-line method divides the total premium or discount evenly across all payment periods, producing the same interest expense/revenue each period.
Example: $2,458 discount / 10 periods = $246 amortised each period. Interest expense each period = $600 cash interest + $246 discount amortisation = $846.
Journal entry for bonds issued at a discount (straight-line, issuer):
Dr. Interest Expense 846
Cr. Discount on Bonds 246
Cr. Cash 600
The straight-line method is allowed under GAAP only when it does not produce results materially different from the effective interest method. "Material" here means a difference large enough to change financial statement users' decisions.
The total interest recognised over the bond's life is the same under both methods. Only the timing per period differs.
When the financial statement date falls between interest payment dates, the company must accrue the portion of interest that has built up since the last payment.
If the FS date is 4 months into a 6-month interest period, accrue 4/6 of the period's interest expense/revenue and premium or discount amortisation.
Example at par: 4/6 x $600 = $400 interest expense, with a $400 credit to Bond Interest Payable.
Example at a premium: 4/6 x $539 = $359 interest expense, 4/6 x $61 = $41 premium amortisation, $400 Bond Interest Payable.
When the next cash payment is made (2 months later), the remaining 2/6 of interest is recognised, the payable is relieved, and cash is credited for the full $600.
Costs to issue bonds (legal fees, accounting fees, registration, underwriting) are recorded as an asset and amortised to expense on a straight-line basis over the bond's life.
Example: $700,000 bonds issued for $735,533 with $12,000 in issue costs.
Dr. Cash 723,533 ($735,533 minus $12,000)
Dr. Debt Issue Costs 12,000
Cr. Bonds Payable 700,000
Cr. Premium on BP 35,533
At each interest date: Dr. Debt Issue Expense 2,000 ($12,000 / 6 periods), Cr. Debt Issue Costs 2,000.
Issuer: Bonds Payable always shows the face amount. The premium or discount is a valuation account. Carrying value = Bonds Payable minus Discount, or Bonds Payable plus Premium. This equals the PV of future cash flows at the original market rate. The premium/discount shrinks to zero by maturity, at which point carrying value equals face value.
Investor: Investment in Bonds shows face value. Discount or Premium on Bond Investment adjusts it. Carrying value follows the same logic as the issuer side. If classified as HTM, the investment is carried at amortised cost (not marked to market). If classified as AFS or TS, a fair value adjustment is also recorded.
Issuer: Interest expense lowers net income. Amortising a discount increases interest expense above cash interest. Amortising a premium decreases interest expense below cash interest.
Investor: Interest revenue increases net income. Amortising a discount increases interest revenue above cash interest received. Amortising a premium decreases interest revenue below cash interest received.
The investor removes the Investment in Bonds and any remaining discount or premium from the books, records cash received, and recognises a gain or loss.
Example: Face value $10,000, selling price $8,000, remaining discount $1,000.
Dr. Cash 8,000
Dr. Discount on Bonds 1,000
Dr. Loss on Sale 1,000
Cr. Investment in Bonds 10,000
Carrying value was $9,000 (10,000 minus 1,000). Sold for $8,000. Loss = $1,000.
At maturity: The premium/discount is fully amortised. The issuer debits Bonds Payable and credits Cash for the face amount. The investor debits Cash and credits Investment in Bonds.
Early extinguishment (before maturity): The issuer removes Bonds Payable and any remaining discount or premium, records the cash paid (call price), and recognises a gain or loss.
Example: $700,000 face value bonds with carrying value $676,288 called at $685,000.
Dr. Bonds Payable 700,000
Dr. Loss on Early Extinguishment 8,712
Cr. Discount on BP 23,712 (700,000 minus 676,288)
Cr. Cash 685,000
Some bond indentures allow bondholders to convert their bonds into shares of the issuer's stock. This conversion feature makes bonds more attractive, so the issuer can typically get a higher price.
Under GAAP, convertible bonds are accounted for identically to nonconvertible bonds until conversion occurs.
Upon conversion (book value method): the bonds payable and any remaining discount or premium are removed, and the carrying value becomes the value of the new shares.
Example: $50,000 face value bonds with $1,000 remaining discount converted to common stock.
Dr. Bonds Payable 50,000
Cr. Discount on BP 1,000
Cr. Common Stock 49,000
No gain or loss is recognised under the book value method.
If a debt investment's fair value drops below its amortised cost (carrying value), it may be impaired. Temporary declines are handled through the normal FV adjustment. If the impairment is other than temporary (OTT), the loss (or a portion of it) must be recognised in net income. The concept that OTT losses hit net income is exam-relevant, though the detailed mechanics are not tested in this course.
Students often think cash interest changes each period. It does not. Cash interest is always face value times stated rate, and it stays the same every period. What changes under the effective interest method is the recognised interest expense/revenue.
Students sometimes believe interest expense is calculated using the stated rate. Under GAAP, interest expense/revenue on the income statement uses the effective market rate applied to the carrying value. The stated rate determines only the cash payment.
Students frequently mix up which direction the carrying value moves. For a premium, it falls toward face value. For a discount, it rises toward face value. Both arrive at face value by maturity.
Students sometimes think the straight-line method and effective interest method produce different total interest over the bond's life. They do not. The total is identical; only the per-period allocation differs.
⚠️ Know the effective interest method cold: interest expense = carrying value x market rate per period. This is the most tested calculation in the chapter.
⚠️ Be able to prepare journal entries for bond issuance and interest payment at par, premium, and discount, for both issuer and investor.
⚠️ Understand how to accrue interest when the FS date is between payment dates (prorate both the interest and the amortisation).
⚠️ Know that interest expense recognised by the issuer differs from cash interest paid because the premium or discount is amortised to interest expense.
⚠️ Be ready to compute carrying value at any point: face value plus remaining premium (or minus remaining discount).
⚠️ Know the journal entry for early extinguishment: remove Bonds Payable, remove remaining discount/premium, record cash paid, and plug the gain or loss.
⚠️ Know the book value method for convertible bonds: carrying value of the bonds becomes the equity credited, no gain or loss.
⚠️ Understand that OTT impairment losses on AFS debt securities are recognised in net income (concept-level, not detailed mechanics).
True or false: Under the effective interest method, interest expense is the same amount each period. (False, it changes because the carrying value changes.)
Fill in the blank: The carrying value of bonds issued at a discount ___ over time toward face value. (Increases.)
True or false: Under the straight-line method, the total interest recognised over the bond's life differs from the effective interest method. (False, the totals are the same.)
Fill in the blank: Apex has Bonds Payable of $500,000 and Discount on BP of $10,000. The carrying value is ___. ($490,000.)
True or false: When convertible bonds are converted using the book value method, a gain or loss is recognised. (False, no gain or loss.)
Q: Why is interest expense recognised by the bond issuer usually different from cash interest paid to bondholders?
A: Because the premium or discount on bonds is amortised to interest expense. Under GAAP, interest expense is calculated using the effective market rate times the carrying value, while cash interest is face value times the stated rate.
Q: A company issued bonds at par on 30 September, with semi-annual interest payments of $120,000 due 31 March and 30 September each year, beginning 31 March. In its 31 December annual income statement, how much interest expense should it recognise?
A: $60,000. Issued at par so no premium or discount. Three months have elapsed (October, November, December) out of the six-month interest period. 3/6 x $120,000 = $60,000.
Q: Ace Co issued bonds with a face value of $50,000. Currently, the carrying value is $48,000. What is the balance in Ace's Discount on Bonds Payable account?
A: $2,000. Carrying value = Face value minus Discount. $50,000 minus $48,000 = $2,000 remaining discount.
Q: Beta Corp sold its Apex Bonds (face value $100,000) for $80,000. At the time of the sale, Beta had $5,000 in its Discount on Bonds account. What is Beta's gain or loss?
A: $15,000 loss. Carrying value = $100,000 minus $5,000 = $95,000. Sold for $80,000. Loss = $95,000 minus $80,000 = $15,000.
Q: Bonds with a face value of $50,000 and a remaining discount of $1,000 are converted to common stock under the book value method. What is the journal entry?
A: Dr. Bonds Payable $50,000, Cr. Discount on BP $1,000, Cr. Common Stock $49,000. The carrying value ($49,000) becomes the value of the equity. No gain or loss.
Q: $700,000 face value bonds are called when their carrying amount is $676,288 and the call price is $685,000. What is the gain or loss?
A: $8,712 loss on early extinguishment. The issuer pays $685,000 to retire debt with a carrying value of $676,288. The excess cash paid ($685,000 minus $676,288 = $8,712) is a loss.
The effective interest method is an application of the matching principle: interest expense is recognised in proportion to the outstanding obligation each period. The investment classification discussion (HTM, AFS, TS) links directly to the investments chapters where equity and debt securities are categorised. Early extinguishment connects to the broader theme of gains and losses on disposal, which appears across asset disposals, debt retirements, and investment sales. Convertible bonds sit at the intersection of debt and equity accounting, foreshadowing more complex topics on stockholders' equity.
Bond amortisation, effective interest method, straight-line amortisation, premium amortisation, discount amortisation, carrying value, book value, valuation account, interest expense, interest revenue, bond journal entries, accrued interest, debt issue costs, underwriting fees, early extinguishment, callable bonds, call price, gain or loss on bonds, convertible bonds, book value method, held-to-maturity, amortised cost, AFS debt securities, OTT impairment, other than temporary, sinking fund, bond redemption, ACCTG 472, intermediate financial accounting, Penn State, Chapter 14 bonds