Bond Accounting: Premium, Discount, and Effective Interest Method Examples

Bond Issuance Fundamentals

Bond accounting is a staple of the CPA FAR exam. Bonds are issued at par when the stated (coupon) rate equals the market rate, at a premium when the stated rate exceeds the market rate (investors pay more for the higher coupon), and at a discount when the stated rate is below the market rate (investors pay less to compensate for the lower coupon). Understanding the effective interest method of amortization is essential for calculating interest expense and the carrying amount of bonds over time.

Issuance at a Discount

Example

On January 1, Year 1, a company issues $1,000,000 of 5-year bonds with a stated rate of 6% (annual payments) when the market rate is 8%. The bonds pay interest annually on December 31.

Issue price calculation:

• PV of principal: $1,000,000 x PV factor (8%, 5 years) = $1,000,000 x 0.6806 = $680,583
• PV of interest payments: $60,000 x PV annuity factor (8%, 5 years) = $60,000 x 3.9927 = $239,564
• Issue price: $680,583 + $239,564 = $920,147
• Discount: $1,000,000 - $920,147 = $79,853

Issuance entry:

• Debit: Cash $920,147
• Credit: Bonds Payable $1,000,000
• Debit: Discount on Bonds Payable $79,853

Effective Interest Amortization Schedule (Discount)

Under the effective interest method, interest expense equals the carrying amount times the market rate. The difference between interest expense and the cash payment is the discount amortization.

• Year 1: Carrying amount $920,147. Interest expense: $920,147 x 8% = $73,612. Cash paid: $60,000. Discount amortization: $13,612. Ending carrying amount: $933,759.
• Year 2: Carrying amount $933,759. Interest expense: $933,759 x 8% = $74,701. Cash paid: $60,000. Discount amortization: $14,701. Ending carrying amount: $948,460.
• Year 3: Carrying amount $948,460. Interest expense: $948,460 x 8% = $75,877. Cash paid: $60,000. Discount amortization: $15,877. Ending carrying amount: $964,337.

Notice that interest expense increases each year because the carrying amount grows as the discount is amortized. By maturity, the carrying amount reaches $1,000,000.

Issuance at a Premium

Example

On January 1, Year 1, a company issues $500,000 of 4-year bonds with a stated rate of 7% (annual payments) when the market rate is 5%.

Issue price:

• PV of principal: $500,000 x 0.8227 = $411,351
• PV of interest: $35,000 x 3.5460 = $124,108
• Issue price: $535,459
• Premium: $35,459

Issuance entry:

• Debit: Cash $535,459
• Credit: Bonds Payable $500,000
• Credit: Premium on Bonds Payable $35,459

Effective Interest Amortization (Premium)

• Year 1: Carrying amount $535,459. Interest expense: $535,459 x 5% = $26,773. Cash paid: $35,000. Premium amortization: $8,227. Ending carrying amount: $527,232.
• Year 2: Carrying amount $527,232. Interest expense: $527,232 x 5% = $26,362. Cash paid: $35,000. Premium amortization: $8,638. Ending carrying amount: $518,594.

With a premium, interest expense decreases each year because the carrying amount declines as the premium is amortized. The carrying amount converges to the face amount at maturity.

Bonds Issued Between Interest Dates

When bonds are issued between interest payment dates, the buyer pays accrued interest from the last payment date to the issue date. At the next payment date, the full coupon is paid, and the issuer effectively refunds the buyer's prepaid interest.

Example

Bonds with a face value of $200,000 and a 6% annual rate (semiannual payments on June 30 and December 31) are issued on March 1. Accrued interest for 2 months: $200,000 x 6% x 2/12 = $2,000.

• Debit: Cash (issue price + $2,000)
• Credit: Bonds Payable (face value, adjusted for premium/discount)
• Credit: Interest Payable $2,000

Early Extinguishment

When bonds are retired before maturity, the difference between the reacquisition price and the carrying amount produces a gain or loss. Under ASC 470-50, gains and losses on debt extinguishment are reported in income from continuing operations.

Example

A company calls $1,000,000 face value bonds at 103 (reacquisition price: $1,030,000). The carrying amount is $975,000 (face minus unamortized discount of $25,000). Unamortized debt issuance costs are $5,000.

• Loss on extinguishment: $1,030,000 - $975,000 + $5,000 = $60,000
• Debit: Bonds Payable $1,000,000
• Debit: Loss on Extinguishment $60,000
• Credit: Discount on Bonds Payable $25,000
• Credit: Debt Issuance Costs $5,000
• Credit: Cash $1,030,000

Key Exam Tips

• Under the effective interest method, interest expense = carrying amount x market rate; cash paid = face value x stated rate.
• Discount bonds: interest expense increases over time; premium bonds: interest expense decreases.
• The carrying amount always converges to face value at maturity regardless of premium or discount.
• Bonds issued between interest dates require collecting accrued interest from the buyer.
• Gains and losses on extinguishment are reported in continuing operations, not as extraordinary items.