Financial Accounting: An Integrated Statements Approach, 2nd Edition

Every six months after the bonds are issued, interest payments of $6,000 are made,

beginning on June 30. As we discuss in Chapter 13, interest payments are reported in

the operating activities section of the statement of cash flows. The first interest pay-

ment is recorded as shown below.

At the maturity date, the payment of the $100,000 principal is recorded as follows:

Bonds Issued at Discount

If the market rate is higherthan the contract rate, the bonds will sell at a discount, or

for less than their face amount. This is because buyers are not willing to pay the full

face amount for bonds which pay a lower rate of interest (contract rate) than they could

earn on similar bonds. The discount, in effect, represents the amount necessary to

make up for the difference between the market rate of interest and the contract rate of

interest.

Continuing with our prior example, assume that the Moore Co. $100,000, 12%,

five-year bonds were issued when the market rate of interest was 13% instead of 12%.

As shown in Exhibit 12, the semiannual interest payments are not affected by the

change in the market rate of interest. However, the market rate of interest of 13% re-

quires different present value factors for discounting the interest payments and the

face value of the bonds. As a result, the price of the bonds drops to $96,406, as shown

in Exhibit 13. As discussed previously, the difference between the price of the bonds

and their face value of $3,594 is called the bond discount.

Face Value of Bond $100,000

Price of the Bond  96,406

Discount on Bond $ 3,594

The following journal entry records the issuance of the Moore Co. bonds at a

discount:

454 Chapter 10 Liabilities

June 30 Interest Expense 6,000

Cash 6,000

SCF BS IS

OT AT SET Ec

Dec. 31 Bonds Payable 100,000

Cash 100,000

SCF BS IS

FT AT LT —

Jan. 1 Cash 96,406

Discount on Bonds Payable 3,594

Bonds Payable 100,000

SCF BS IS

Fc Ac Lc —

The $3,594 discount may be viewed as the amount that is needed to convince investors

to accept a contract rate below the market rate. You may think of the discount as the

market’s way of adjusting a bond’s contract rate of interest to the higher market rate

of interest. Using this logic, generally accepted accounting principles require that bond

discounts be amortized as interest expense over the life of the bond.

Q.General Motors

issued $500,000 of 8%

five-year bonds that pay

interest annually when the

annual market rate of inter-

est is 10%. What is the

price of the bonds?

A.Interest Payment

$500,0008% (contract

rate) $40,000

Price [$500,000

(.62092)*][$40,000

(3.79079)**]

Price $310,460

$151,632 $462,092

* Present Value of $110%, 5

** Present Value of Annuity of

$110%, 5