Difficulty: Intermediate to Advanced | Prerequisites: Chapter 6 (Time Value of Money), comfort with present value calculations
Bonds are one of the primary ways companies raise long-term capital, and accounting for them is one of the heaviest topics in intermediate financial accounting. This chapter builds directly on TVM concepts from Chapter 6: every bond price is just the present value of its future cash flows. You need to understand how bonds are issued at par, at a premium and at a discount, how the resulting premium or discount is amortised over the bond's life, and what happens when bonds are retired early or issued between interest dates. If you are not yet confident with PV calculations, revisit Chapter 6 before tackling this material.
A bond's price equals the PV of its coupon payments plus the PV of its face value at maturity, both discounted at the market rate. When the coupon rate differs from the market rate, the bond is issued at a premium or discount, which must be amortised over the bond's life. The effective interest method (GAAP) bases each period's interest expense on the carrying value times the market rate.
Face amount (par value, principal)
The single cash payment made to the bondholder at maturity. This is the amount printed on the bond certificate. Think of it as the "sticker price" the issuer promises to repay.
Maturity
The date on which the final bond payment is made and the face amount is returned to the bondholder.
Coupon payment
The periodic interest payment made to bondholders until maturity. Calculated as Face amount x Coupon rate (adjusted for the payment frequency). In simple terms, it is the cash interest the bondholder receives each period.
Coupon rate (stated rate, nominal rate)
The annual interest rate stated on the bond, expressed as a percentage of the face amount. This rate is set at issuance and does not change.
Discount rate (effective yield, market rate of interest)
The rate the market demands for bonds of similar risk at the time of issuance. This is the rate used to discount the bond's future cash flows to arrive at its price. Think of it as what investors actually require.
Premium
The amount by which a bond's issue price exceeds its face value. This happens when the coupon rate is higher than the market rate: investors are willing to pay extra for the above-market coupons.
Discount (on bonds payable)
The amount by which a bond's issue price falls below its face value. This happens when the coupon rate is lower than the market rate: investors pay less to compensate for the below-market coupons.
Amortisation
The gradual reduction of a bond premium or discount over the life of the bond, so that the carrying value converges to face value at maturity.
Effective interest method
The GAAP-preferred method of amortising a premium or discount. Interest expense each period equals the carrying value at the start of the period multiplied by the market rate at issuance.
Straight-line method
An alternative (not GAAP) method that amortises an equal amount of premium or discount each period. Simpler, but less precise.
A bond has two cash-flow components: the periodic coupon payments (an annuity) and the face amount returned at maturity (a single sum).
PV of bond = (Coupon payment x PVA factor) + (Face value x PVF factor)
For semiannual bonds, divide the annual coupon rate and the market rate by 2, and multiply the number of years by 2.
If PV > face value, the bond sells at a premium (coupon rate > market rate).
If PV < face value, the bond sells at a discount (coupon rate < market rate).
At par (coupon rate = market rate):
Debit Cash (face value)
Credit Bonds Payable (face value)
At a premium (coupon rate > market rate):
Debit Cash (PV of bond)
Credit Bonds Payable (face value)
Credit Premium on Bonds Payable (plug: PV minus face)
At a discount (coupon rate < market rate):
Debit Cash (PV of bond)
Debit Discount on Bonds Payable (plug: face minus PV)
Credit Bonds Payable (face value)
Combines the premium or discount directly into the Bonds Payable account rather than using a separate contra account. The net carrying value is the same either way.
Each period, three amounts are calculated:
Interest expense = Book value at start of period x Yield (market) rate per period
Interest payment = Face amount x Coupon rate per period
Amortisation = Interest expense minus Interest payment
For a premium: interest expense < interest payment, so the difference reduces the premium and the carrying value declines toward face.
For a discount: interest expense > interest payment, so the difference reduces the discount and the carrying value rises toward face.
Each period's new carrying value becomes the starting book value for the next period.
A $10,000,000, 20-year bond issued at 102 (premium). Annual coupon rate 4%, market rate 3.855%, semiannual payments.
Date | Cash Payment | Effective Interest | Premium Amortisation | Carrying Value |
|---|---|---|---|---|
1/1/23 | $10,200,000 | |||
6/30/23 | $200,000 | $196,605 | $3,395 | $10,196,605 |
12/31/23 | $200,000 | $196,540 | $3,460 | $10,193,145 |
6/30/24 | $200,000 | $196,472 | $3,527 | $10,189,618 |
Notice: the cash payment stays constant (it is contractual), but effective interest shrinks each period because the carrying value is falling.
At par:
Debit Interest Expense (face x coupon rate / 2)
Credit Interest Payable
Premium:
Debit Interest Expense (BV x yield rate / 2)
Debit Premium on BP (difference)
Credit Interest Payable (face x coupon rate / 2)
Discount:
Debit Interest Expense (BV x yield rate / 2)
Credit Interest Payable (face x coupon rate / 2)
Credit Discount on BP (difference)
Total premium or discount is divided equally across all periods.
The fixed amortisation amount per period is added to (discount) or subtracted from (premium) the coupon payment to arrive at interest expense.
Simpler to compute, but interest expense is the same every period, which does not reflect the changing carrying value.
Debit Bonds Payable (face)
Credit Cash (face)
In the year before maturity, Bonds Payable must be reclassified as a current liability.
A firm may repurchase its bonds on the open market and retire them.
The market price at repurchase will likely differ from carrying value because market rates have changed.
At par: Debit Bonds Payable (face), Credit Cash (market price), with any difference as an Early Extinguishment Gain or Loss (plug).
Premium bond: Debit Bonds Payable (face) and Premium on BP (balance at repurchase date), Credit Cash (market price) and Early Extinguishment Gain (plug).
Discount bond: Debit Bonds Payable (face) and Early Extinguishment Loss (plug), Credit Discount on BP (balance at repurchase date) and Cash (market price).
When a bond is sold between coupon dates, the buyer pays the issue price plus accrued interest.
The issuer credits the accrued interest to Interest Payable.
Accrued interest = (Coupon rate / 2) x Face x (months since last coupon date / 6).
This ensures that at the next coupon payment, each party bears only its share of the interest period.
If the bond's coupon dates do not align with the company's fiscal year-end, interest expense and any premium or discount amortisation must be pro-rated.
Example: a bond with a June 30 / December 31 coupon schedule and a September 30 fiscal year-end would recognise 3/6 of the second period's interest expense at September 30.
Bond issuance costs include printing, legal fees, accounting fees and commissions.
These costs reduce the cash proceeds and increase the effective discount (or reduce the premium).
Economically similar to bonds: an obligation to pay cash over future periods.
Initially recorded at PV. Interest expense recognised each period. Any discount or premium is amortised.
When a note is issued for property, goods or services, check whether the stated interest rate is fair. If not, impute a market rate.
Pay no periodic coupons. The entire return comes from the difference between the discounted issue price and the face value at maturity.
Interest expense each period is entirely from amortisation of the discount.
Settlement: the borrower and lender agree to settle the debt for less than the carrying amount.
Borrower records a Gain on Troubled Debt for the difference.
Lender records a Loss on Settlement.
If a non-cash asset is transferred, it is measured at fair value. Any difference between carrying amount and fair value is a separate gain or loss on the asset.
Modification of terms: the original loan terms are changed (lower rate, extended maturity, reduced principal).
At issuance, firms may elect to report liabilities at fair value instead of amortised cost.
Changes in fair value due to credit risk go to OCI.
Changes due to general interest rate movements go to Net Income.
A "fair value adjustment" account captures the difference between fair value and amortised cost on the balance sheet.
Formula | Expression | Notes |
|---|---|---|
Bond price | PV = (Coupon x PVA factor) + (Face x PVF factor) | Both factors use market rate and total periods |
Coupon payment (semiannual) | Face x (Coupon rate / 2) | Fixed by the bond contract |
Interest expense (effective method) | Book value at start of period x (Market rate / compounding frequency) | Changes each period |
Interest payment | Face x (Coupon rate / compounding frequency) | Constant each period |
Amortisation per period (effective) | Interest expense minus Interest payment | Positive = discount amortisation; negative = premium amortisation |
Amortisation per period (straight-line) | Total premium or discount / Total number of periods | Equal each period |
Accrued interest (between dates) | Face x (Coupon rate / 2) x (Months elapsed / 6) | For semiannual bonds issued or traded between coupon dates |
When Apple or Microsoft issues billions in corporate bonds, the market price is determined by exactly the PV calculation covered here. Investment banks, credit analysts and corporate treasurers all build amortisation schedules to track interest expense over the bond's life. The effective interest method is how most public companies report bond-related interest on their income statements.
Students frequently confuse the coupon rate with the market rate. The coupon rate is contractual and fixed; the market rate is what investors demand and determines the bond's price.
Students sometimes think a premium bond is "better" for the issuer. It is not. A premium simply means the issuer is paying above-market coupons, so investors pay more upfront. The total cost of borrowing, over the bond's life, reflects the market rate either way.
Some students apply the straight-line method on exams and assume it is acceptable under GAAP. It is not. The effective interest method is required unless the difference is immaterial.
Students often forget to update the carrying value each period before computing the next period's interest expense under the effective method. The carrying value changes every period.
⚠️ Be able to prepare a full amortisation schedule for both premium and discount bonds under the effective interest method. This is a near-certainty on the exam.
⚠️ Know the journal entries at issuance, at each interest date and at maturity for both premium and discount scenarios.
⚠️ Early extinguishment: be ready to calculate the gain or loss. You need the carrying value at the retirement date, not the original issue price.
⚠️ Bonds issued between interest dates: expect a question requiring you to compute accrued interest and adjust the issuance entry.
⚠️ Understand the difference between the gross method and the net method at issuance. The net carrying value is identical; the presentation differs.
True or False: A bond issued at a premium has a coupon rate lower than the market rate.
False. A premium means the coupon rate is higher than the market rate.
Fill in the blank: Under the effective interest method, Interest Expense = ______ x ______.
Book value at start of period x Market (yield) rate per period.
True or False: The straight-line method is the preferred method under GAAP.
False. The effective interest method is GAAP.
Fill in the blank: For a discount bond, the carrying value ______ over time as the discount is amortised.
Increases (rises toward face value).
True or False: When bonds are issued between interest dates, the issuer receives the issue price plus accrued interest from the buyer.
True.
Q: A company issues a $1,000,000, 10-year bond with a 6% annual coupon, paid semiannually. The market rate at issuance is 8%. Is this bond issued at a premium or a discount, and why?
A: At a discount, because the coupon rate (6%) is below the market rate (8%). Investors will pay less than face value to compensate for the below-market coupons.
Q: Using the effective interest method, how do you calculate interest expense for the first period on a discount bond?
A: Interest expense = Carrying value at start of period x (Market rate / 2 for semiannual). For example, if the bond's carrying value is $864,098 and the market rate is 8%, interest expense = $864,098 x 4% = $34,564.
Q: A $5,000,000 bond with a carrying value of $5,120,000 is retired early for $5,050,000. What is the gain or loss?
A: Gain on early extinguishment = Carrying value minus Market price = $5,120,000 minus $5,050,000 = $70,000 gain.
Q: How does the journal entry differ when a bond is issued on March 1 rather than the January 1 interest date?
A: The issuer collects accrued interest for January and February from the buyer. Cash is debited for the issue price plus the accrued interest. The accrued interest portion is credited to Interest Payable (not revenue), so that when the full coupon is paid on June 30, each party bears only its share.
Q: Under the straight-line method, how is the amortisation amount per period determined?
A: Total premium or discount at issuance divided by the total number of coupon periods. This amount is the same every period, unlike the effective interest method.
This chapter is the issuer's side of long-term debt. Chapter 12 (Investments) covers the investor's side: how to account for bond investments classified as HTM, Trading Securities or Available for Sale. The journal entries mirror each other, so understanding one side deeply helps with the other.
TVM concepts from Chapter 6 are the computational engine behind every bond price and amortisation schedule here. If you can price a bond confidently, lease accounting (which uses the same PV-of-annuity logic) becomes much more approachable.
Troubled debt restructuring connects to broader credit-risk and impairment topics that appear throughout intermediate accounting.
Bonds payable, bond pricing, bond valuation, premium on bonds, discount on bonds, effective interest method, straight-line method, amortisation schedule, coupon rate, stated rate, nominal rate, market rate, effective yield, face value, par value, maturity, early extinguishment, reacquisition, accrued interest, bonds between interest dates, zero-coupon bond, deep discount bond, troubled debt restructuring, debt settlement, modification of terms, fair value option, long-term notes payable, imputed interest, ACC 472, intermediate accounting, Chapter 14