bond discounts if an investor is
choosing between two alternatives of
similar risk both yielding 6% interest
the investor would not be better off by
choosing one over the other however if
the bond alternative is offering 5%
while the similar risk alternative
yields 7% a rational investor would
choose the alternative with the higher
rate of return which is 7% the business
cannot sell the bond at its face value
in such a scenario it would be able to
sell it if it offered that at a discount
let's illustrate assume that a business
offered to issue a bond that heals 5%
while the interest rate of a similar
risk investment is 7% in order to sell
the bond the business sells it's at a
discount so instead of selling it at its
face value of $1,000 it sells it for 900
only in this case the business collects
$900 now to pay the bonds face value at
maturity after 5 years which is $1,000
so even though the business is paying 5%
only it had rewarded the investor at the
end by paying an extra $100 the business
pays an annual interest to the bond
holder at the end of each year which has
$1,000 time 5% which is equal to $50 for
each of the 5 years
the company receives $900 and issues to
the investor a bond with a face value of
$1,000 so we call it's issued at a
discount
it is usually mentioned in a percent
form so it would be mentioned that it
was issued at ninety which means ninety
percent of the bonds value the entry
would be to debit cash for nine hundred
dollars and credit bonds payable with
the same amount from an accounting
perspective and based on accrual
accounting this $100 should be fairly
distributed among the periods of benefit
so we will distribute the 100 in our
example by using the straight-line
method for simplicity although the
effective interest method should be used
which is usually a topic of an
intermediate accounting course by
distributing the 100 dollars over five
years the share of each year is twenty
dollars so even though the business is
paying fifty dollars in cash it will
affect its expenses by the additional
twenty dollars as well so effective
interest is equal to the fifty dollars
which is paid and the twenty dollars
which is going to be paid later so it is
equal to seventy dollars the entry would
be to debit interest expense for seventy
dollars credit cash for fifty dollars
and credit bonds payable for twenty
dollars now the balance of bonds payable
is nine hundred and twenty dollars after
the second year the same entry is done
again and again and the balance of bonds
payable is nine forty and so on until
the fifth year where the balance of the
bonds payable is one thousand dollars
when it is paid to the bond holder the
following entry is done debit bonds
payable for one thousand dollars and
credit cash for one thousand dollars
Bonz premium now let's assume the
opposite let's assume that the bond
offers an interest of 7% while the
investment of similar risk in the market
is 5% a rational investor would
certainly choose to invest in the bond
however the business managers are also
rational so they won't sell the bond for
$1,000 and pay 7% interest while they
know that the market rate is 5% so they
will sell the bond at a premium let's
say at 110 which means 10% above its
face value which is $1100 assume that
the business offered to issue a bond
that yields 7% while the interest rate
of a similar risk investment is 5% the
business in this case can sell the bond
at a premium so instead of selling it at
its face value of $1,000 it could sell
it for $1100 in this case the business
collects $1,100 now to pay its face
value at maturity after 5 years which
has $1,000 so even though the business
is paying 7% it had received from the
investor $100 at the beginning when it
issued the bonds the business pays an
annual interest to the bond holder at
the end of each year which is 1,000
dollars times 7% equal $70 for each of
the 5 years
their company receives $1,100 and issue
the investor a bond with a face value of
$1,000 so we call its issued at a
premium the entry would be to debit cash
for $1,100 and credit bonds payable with
the same amount from an accounting
perspective and based on accrual
accounting this $100 should be fairly
distributed among the periods of benefit
so we will distribute the $100 in our
example by using the straight line
method for simplicity although also the
effective interest method should be used
this is usually also a topic of
intermediate accounting course by
distributing there 100 dollars over five
years the share of each year is $20 so
even though the business is paying $70
in cash
it will affect its expenses by deducting
$20 as it is collected in advance in the
form of a premium so the effective
interest is equal to the $70 which is
paid - the $20 which is already
collected in advance so it is equal to
$50 the entry would be to debit interest
expense for $50 debit bonds payable for
$20 and credit cash for $70 now the
balance of the bonds payable is 1080
dollars after the second year the same
entry is done again and the balance of
bonds payable is 1060 and so on until
the fifth year where the balance of
bonds payable is $1,000 when it is paid
to the bond holder the following entry
is done debit bonds payable for $1000
and credit cash for the same amount