Bonds are often issued by a corporation to help finance an expensive asset. Bonds are part of the corporation's debt and will usually be reported as a long-term liability.
Most bonds require the issuing corporation to pay interest semiannually and to pay the face or principal amount on the date that the bonds mature. Under the accrual method of accounting, the corporation must report a bond's accrued interest expense and liability as of the date of its financial statements.
Issuing bonds instead of common stock provides a corporation with two benefits. First, the ownership interest of its common stockholders is not diluted. Second, the bond interest expense is deductible on the corporation's income tax return. The tax deduction of bond interest expense will result in a tax savings for a profitable corporation—effectively reducing the corporation's cost of the interest payments to bondholders.
If a corporation issues a bond and receives more than the bond's face amount (excluding any accrued interest), the bond is said to have sold at a premium. This additional amount is recorded in a liability account entitled Premium on Bonds Payable or Bond Premium. If the amount received is less than the bond's face amount, the bond is said to have been sold or issued at a discount. The shortfall between the amount received (excluding accrued interest) and the bond's face amount is recorded in a contra liability account entitled Discount on Bonds Payable or Bond Discount.
The balances in the accounts Premium on Bonds Payable and Discount on Bonds Payable must be reduced to zero over the life of the bonds. The systematic reduction is known as amortization. The amortization of the bond premium will cause Interest Expense to be less than the amount of the interest payments. The amortization of bond discount will cause Interest Expense to be more than the interest payments.
The market value of an existing bond will change in the opposite direction of the change in market interest rates. In other words, if the market interest rates increase, the market value of an existing bond will decrease. A decrease in market interest rates will cause the market value of an existing bond to increase.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.