Corporations issue bonds as a way of borrowing additional capital from the general investing public. When the rate of interest for a bond is less than the market interest rate on the date of issuance, the company must amortize this discount for financial statement purposes. Moreover, if the company extinguishes the bond prior to the maturity date by repurchasing it in the open market, the company makes final journal entries to remove the bonds from its books and ceases reporting amortization.
Calculate the discount on the bond. The discount is equal to the difference in the face amount of the bond, which is the principal the corporation agrees to pay the investor at the bond maturity date, and the market rate of interest on the date the company issues the bond. For example, if a company issues a 5-year bond with a face value of $1 million with annual interest payments of 10 percent at a time when the market interest rate is 12.5 percent, the company will sell the bond at a discount equal to $50,000 to account for the difference in interest rates.
Post journal entries for issuance of bond and the discount. A debit entry of $950,000 to the company’s cash account is necessary to reflect the inflow of cash at the time of issuing the bond. Issue a second debit entry of $50,000 to a bond discount account and a credit entry of $100,000 to bonds payable to reflect the bond’s principal repayment liability.
Record the amortization of the bond discount on each interest payment date. Since the interest accrues on an annual basis, the company must record a debit entry of $125,000 to interest expense on December 31 each year. However, a portion of this interest expense relates to the amortization of the bond discount, which requires a $25,000 credit entry to reduce the balance in the bond discount account, as well as a $100,000 credit entry to cash to reflect the annual 10-percent interest payment.
Remove bond accounts for early extinguishments. The company will pay the market price when extinguishing its own bond, and therefore, you must record a debit entry to the bonds payable account for the balance that remains. A credit entry is also necessary to the cash account for the price the company pays to extinguish the bond.
Calculate gain or loss on extinguishing the bond before maturity date. The difference between the price the company pays to extinguish the bond and the remaining balance in the bonds payable account less the remaining balance in the bond discount account is equal to the gain or loss it must recognize. A purchase price that is less than the bonds payable balance minus the remaining discount is a gain (credit) and a price that is more reflects a loss (debit).
Amortization is also necessary when the corporation issues a bond at a premium, meaning the stated rate of interest on the bond exceeds the market rate of interest. Moreover, the accounting principles remain the same, but instead of creating a bond discount account, you credit a bond premium account.