What is the amortization of discount on bonds payable?
A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. By doing so, investors earn a greater return on their reduced investment.
If so, the issuing entity stores the amount of this discount (the difference between the face value and the amount paid) in a contra liability account, and amortizes the amount of this reduced payment over the term of the bonds, which increases the amount that the business records as interest expense. The net result is a total recognized amount of
interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold.
The concept is best described with the following example.
ABC International issues $10,000,000 of bonds at an interest rate of 8%, which is somewhat lower than the market rate at the time of issuance. Accordingly, investors pay less than the face value of the bonds, which increases the effective interest rate that they receive. Thus, ABC does not receive the face value of $10,000,000 for the bonds, but rather $9,900,000, which is a discount from the face value of the bonds.
ABC records the initial receipt of cash with this entry: