Discount on Bonds

All right. Now let's move on to discounted bonds. And after you're done with this lesson, I want you guys to compare the discounted bonds with the premium bonds that we're going to be studying in the next lesson and see how they're basically the exact opposite of each other. All right. So let's start here with discounted bonds and then we'll do premium bonds in the next lesson. So bond is issued at a discount when the stated rate is. Do you guys remember compared to the market rate? Well, the stated rate, let's say is 8%. We're in a situation where we're saying, Hey, we're offering 8% interest and the market is offering 10% interest. Well, in this case, we're gonna issue at a discount, right? Because the stated rate is less than the market rate. So the market people would rather buy the bonds on the market right there offering more interest. So they would rather buy those bonds as investments rather than our bonds. So our bonds are gonna have to sell at a discount to be able to to sell them at all. Okay, So let's go on here to our gray box and let's discuss these stated rates versus the market rate. Right? So we have already discussed the situation where we have stated rate equal to the market rate. So that would be a situation where they're both equal to 10%. We're offering 10% on our bonds. The market is offering 10% on the bonds. Well, these bonds will be sold equal to the face value. Right? And these were called face value bonds or par value bonds, Par value as well. Okay, now we're moving on to a situation where the stated rate, let's say would be maybe 8% while the market is offering 10% and this could be any number, right? They could be 5% and 6%,, 9% and 12%. As long as the market rate is greater than the stated rate, what we're gonna be in this situation where the market is offering better bonds than what we're offering. So the price of bonds is going to be less than the face value. And that's the situation we're going to discuss in this video, is these discounted bonds. Okay, so we're focused on discounted bonds. In this video we put a little star right here cause that's what we're focused on next. We have the opposite a situation where we're offering 12%, let's say When the market is offering 10%. Now, our bonds are more enticing to investors and they'd rather buy our bonds than the market. So they're going to sell at a price greater than the face value. And that's a situation where we're selling at a premium. Okay, So remember in all these situations, we're talking about bonds payable. This is a liability of the company. We're getting cash now and that's what's going to be this price of the bond today. We're going to get cash now and then we're gonna have to repay it later. So we're gonna pay interest over the life of the bond and then finally the principal repayment at the end. Okay. So let's look at the Issuance journal entry for a discounted bond On January 1, 2018. ACC Company issues $50,000 of bonds of 9% bonds. So remember 50,000. This is the principal amount. This is the face value. So this is the amount that we use when we calculate our cash interest. The 50,000 With the stated rate right here of 9%. And it tells us that the bonds mature in five years. That's the maturity date will be five years from now, interest is payable semiannually. So remember when you see the semiannual that's to uh interest payments per year on January one and July one, the market interest rate was equal to 10%. So notice in this case we've got a difference. The stated rate is 9%. The market rate is 10%. And usually when you do it in this class, they're gonna tell you something like this. The bonds were issued at 94. Okay. Were issued at 94. And what did we say that this 90 for men? It's a percentage of the face value. Right. The amount of cash we received was a percentage of the face value and it makes sense that it's less than 100%. Right? We're only receiving 94% of the face value because let's look at those interest rates Are stated rate is only 9% were saying, Hey come buy our bonds were giving 9% interest while the rest of the market is saying, Hey come buy our bonds, we're offering 10% interest. People would rather buy the market bonds than our bonds. So we have to offer them at a discount. So let's go ahead and calculate that discount cash that we're going to receive. So the cash received Is not gonna be 50,000 in this case. Oops, let me clean that up. The cash received. Oh boy sorry about that. The cash received is going to be the 50,000 in face value times 94% 940.94. So that's gonna equal 50,000 times 0.94. Let's go ahead and put that in our calculator. Mhm. That comes out to 47,000. Right? So notice we're not receiving the full 50,000 anymore, we're receiving less than that. And why that's because we're offering less interest. People would rather buy the other bonds for 50,000. They would pay 50,000 for the other bonds because they're offering the market rate. But our bonds are offering less than the market rate so they're gonna be willing to pay us less for them. In this case we will only be able to raise 47,000. But make a note that when we have to pay these bonds off at maturity in five years from now, we don't repay them 47,000. We repay them 50,000. These are we repay the principal amount. The full face value of 50,000 is what we're gonna repay in in five years. But we only received 47,000 in cash today because of the lower interest rate. Okay so let's see how that affects our journal entry. We know we're gonna debit cash because we're receiving cash and we just calculated that that's going to be 47,000 right 47,000 in cash. That's gonna be our debit. Now. We also know that we have a bond payable, right? We are going to be paying a we have this liability now and we're gonna be paying off 50,000. Just like I said in our previous lesson on face value bonds, the bonds payable account will always be the face value amount. Okay so the face value of the bonds was 50,000. That has to be what we put into the bonds payable liability. But notice that our our equation doesn't balance here right? Our debits are 47,000. Our credits are 50,000. We need more debits in this case. We need debits of 3000 to balance this out. And this account, what we're gonna use is called discount on bonds payable. Okay so this is an additional debit account here and this is a contra account to the bonds payable account. Okay So remember we talked about those contra accounts. Well it's going to be related to the bonds payable account. In this case it's a debit balance. So let's think about what happens here. We had this credit of 50,000 to the bonds payable. Well we have this related debit of 3000. And what this does is it brings the carrying value of the bond, the book value. So when we show our balance sheet, The balance sheet is going to show, Hey we have bonds payable of 50,000 less a discount of 3000. So the carrying value of the bond on the liabilities is going to show 47,000. Okay. And over the life of the bond, we're gonna be advertising that discount and it's gonna be shrinking until we get to maturity. So we'll see how we deal with that in the interest expense entries coming up. But for now this is very important. This is how we set up our issuance of a discount bond. Okay. So we always put the full face value of bonds payable, the full 50,000 and then the cash amount and the difference between the two. Well that's gonna be the discount or the premium once we get to premiums. Okay in this case we have a discount because we've got less cash than the face value. So let's go ahead and set this up. Our cash increased by 47,000. Right? We had an increase of cash for 47,000. and then we had an increase in bonds payable of 50,000, but it would be less the discount of 3000. Right? We had this debit of 3000 and that comes out to a 47,000 increase in. Let me let me clean that up. That comes out to a 47,000 increase in our liabilities there as well. 47,000 Increase. Right? So our cash went up by 47,000, and our liabilities went up by 47,000 notice the bonds payable account has that full face value because that's the amount that we will pay off at maturity. Alright, so let's pause here and let's move on to the interest expense entry.

Alright so now let's see how we're gonna do interest expense as we go through these first examples. I'm gonna be using the straight line method of amortization. Okay and when I say amortization, we're gonna be advertising that discount, we had a discount of $3000 and we're gonna advertise it over the life of the bond into interest expense. Okay. I'm gonna show you what that means in a second, but I want to make a note to you. The straight line method is not technically gap, it is not gap but in this class it's very easy and they generally use it because most of the time it's not so different from the gap method. Now if your teacher is really gung ho and really wants to teach you the more difficult method, we're going to have a video on that method as well. Just make sure whether your teacher is gonna focus on straight line, effective interest method or both. Okay. You might even need to know both, but for now let's focus on the straight line method just so you can kind of see how this works. And a lot of the principles between straight line and effective are very similar. Okay, so let's go ahead and dive into this interest expense entry and through interest expense is where that discount will disappear. Okay, so let's go ahead and see how this works on january 1st 2018. Abc company issues 50,000 of 9% bonds, maturing in five years interest is payable, semiannually on january 1st and july 1st the market interest rate was equal to 10%. The bonds were issued at 94. So remember that we had that $3,000, we have a $3,000 in the discount. Right? So now that we're focused on the straight line amortization method, we're gonna advertise it using the straight line method over the amount of interest payments we're gonna make. So if you think about it, this is a five year bond, right? This bond is maturing in five years but we're paying interest twice a year. So there's gonna be 10 total interest payments. So each interest payment, we're gonna advertise some of this discount. Okay So we're gonna take that 3000 discount and divide it by 10. And that means that we're gonna advertise 300 per period advertised. Okay? And we're gonna see what this what I keep saying advertised. What does that mean? Well that means we're taking that 3000 that's sitting in the discount account and we're gonna get rid of it over the life of the bond. We don't want it there anymore because remember at maturity we're gonna pay the full 50,000 not the 47,000 that's currently on our books. So we need to Increase the value of this liability up to the up to 50,000 from the 47,000. It's at right now. We need to keep increasing it over the life of the bond until it's worth 50,000 at maturity. Alright. So let's see how that works in this journal entry, we're going to be advertising 300 per period of our discount. But we're also going to be paying cash right just like before we had our cash interest payments where we had 50,000 in principle times the stated rate, right? Were the cash interest that we pay is based on the stated rate. It doesn't matter the market rate. We're saying, hey we're paying 9%. Well we're gonna pay 9%. So the 50,000 in principle times the 9%. That's the legal amount of interest that we owe to these people. And that's gonna be a yearly amount. Just like we discussed with face value bonds. So we have to divide it by two because we're dealing with this semiannual interest. So the 9% is an annual interest amount. So we divided by two because we pay interest twice per year. So each interest payment is gonna be half of the annual amount. So 50,000 times point oh nine divided by two, forgot what we had that in the last video times point oh nine divided by two Comes out to $2,250 and this is the cash interest that will be paid. Okay now I want to make a note between this and the face value bonds in the face value bonds. The cash interest was our interest expense. That's not the case anymore. Unfortunately when we've got a discount or a premium, our interest expense is going to be different from the actual cash interest that we paid. And that's because we're advertising the discount or the premium. So let's go ahead and see how we're gonna advertise this discount. We know that we're gonna have a credit to cash on July one when we have the six months of interest we're paying well we're gonna pay off 2250 in cash. Right? So that's gonna be one of our credits. But notice we also had this discount and the discount had a debit balance right Because we had a credit to bonds payable And then the discount which was lowering the value of bonds payable down to 47,000 we had that $3,000 value. Well we want to get rid of that discount and since it had a debit balance before we get rid of it with credits. And what that's going to be doing is going to be increasing the value of the bond as we keep crediting to these liabilities. Okay so let's go ahead and see what we do here. We're going to credit discount on bonds payable and I'm gonna put discount on BP for bonds payable. So we're gonna be crediting the discount account because remember up here when we first issued the bonds it had a debit balance right. We issued them with a debit balance in the previous video. And now we're gonna be crediting it to get rid of that debit balance. So we have that debit balance of 3000 and we're gonna be advertising it over the 10 interest payments five years twice per year. We're gonna be advertising it 300 per period. So we're gonna have a credit of 300. So what does that do to our discount account? Our discount is now 3000 debit. Right well let me do it as a as a T. Account. Right? We had the T. Account for discount on on bonds payable and it had a debit balance of 3000 in the first entry. Well right now we're crediting it for 300. So that's gonna bring its value down to 2700 as a debit balance. Right? So now the debit balance is only 2700 rather than 3000. Okay So what does that mean the bonds we still have bonds payable? So when we show our our balance sheet we're still gonna show bonds payable of 50,000 But now it's gonna be less discount instead of 3000, the discount is only gonna be 2700. So our face our our bond instead of being 47,000 is now 47,300. So our liability increases right? Because of this credit to discount on bonds payable and it's gonna keep increasing over the life of the bond. Okay so that's what that credit to bonds payable? Does credit to discount on bonds payable? Does it's increasing that carrying value on the balance sheet of our bonds payable. Okay. So the last part of this entry. Well, guess what? This is an interest expense entry. Right? We're paying interest. So we're gonna have interest expense here and that's going to be our debit. So our debit to interest expense. Well, it's going to be the sum of these two. We paid the cash and we're gonna advertise some of the discount of 300. So this comes out to 2550. All right. And this is about as tricky as this class gets. Okay. So if you understood this, wow, I'm really proud of you for getting this on the first try. But I don't expect you to really understand everything we went through. Okay. So we're gonna keep going through this example and then you're gonna see it with premiums on bonds payable. And I hope once you see both of them side by side this will start to make a lot more sense. And then I want you guys to keep hammering this in because this is about as tough as this course is gonna get. Okay, so this is our journal entry right here. We're going to debit interest expense 2550 credit. The discount on bonds payable to lower its value a little bit And we're going to credit cash for the actual cash that we paid out. Okay. So what happened in this entry? Well, our cash decreased by 2250. But what else happened? We had our discount on bonds payable. Remember it had a a debit balance and we credited it. So it has less of a debit balance. So it increased our liabilities right? Just like we saw here before we had a net balance of 47,000, right before this interest expense. Because the discount was sitting at 3000. Well now there's less discount. So our liabilities have increased from 47,000 to 47,300. So that's an increase to our liabilities of 300 and then our interest expense. Well, that's a decrease to equity, right? 2550 decrease to equity. So the decreased equity 2550. The increased the liabilities of 300 that equals the decrease to assets of 2250. This is getting a little bit complicated right now let's keep it going in the next video

Alright, so just like we had in the Face Valley bonds, we're going to be creating an interest payable in this entry, right? Because now we've reached december 31st 2018 and it's time to release our financial statements. We want to show our balance sheet, we want to show our income statement and we're going to do that as of december 31st 2018. So we need to take those six more months of interest this year. So just like before we're gonna have the same cash interest and we're going to calculate it In the same way the 50,000 times the 9% that the bonds say that they pay and we divided by two because its semiannual periods. And that's gonna give us the same cash interest of 2250. Right? And just like before we already calculated that the discount is going to be uh advertised over the 10 periods, right? We had the 3000 discount divided by the 10 payment periods. We have five years with two payment periods each year, 10 total interest payments that came out to 300 per period. Right? So it's the same calculations we did in the last video they carry on here. That's why the straight line method is so easy because we're just gonna be doing 300 per period of this discount. Amortization. Okay, so we've got the cash, we've got the discount. Now the only difference is that actually when I say cash, we're not paying it in cash on december 31st, right? We're gonna be paying it on january 1st of the following year. So this is technically our interest payable that we have as of two as of december 31st is the 2250. So our journal entry is going to look very very similar except instead of cash we're gonna have interest payable on this one. So we know that we're gonna be paying interest tomorrow on january 1st, We're gonna be paying interest of 2250. So we have this liability To pay $2,250 for the six months that have passed. We're also going to credit the discount again. The discount on bonds payable, it's gonna keep decreasing here. Right, another 300 being decreased. And let's go ahead and look at that T-account over here the discount. So remember it started with a $3,000 balance and then we took 300 in our first interest payment. Now another 300. Well now we're sitting at a 2400 debit balance. Right? And just like we saw before that's gonna keep increasing the value of the liability, write the bonds payable, the carrying amount on our balance sheet. It's gonna keep increasing up to that $50,000 par value that we're going to end up paying off on the maturity date. Okay so these are our credits, we have our interest payable that we're gonna pay off tomorrow and then we have the discount that we have to advertise over the 10 periods. And finally we have interest expense. So notice how similar this is to the journal entry we just made above except instead of cash we have interest payable 2550 right there. Okay so our interest payable. This is a liability in this case, right interest payable because we're gonna pay it off tomorrow and that's increasing our liabilities. Same thing with the discount as we get rid of this. This discount balance. It's gonna keep increasing our liabilities up to that par value for the for the bonds and the interest expense. Well that's decreasing our equity because this is an expense on our income statement and that's decreasing our equity by 2550. So everything stays balanced here. This entry is not very different from the previous entry we made. The main difference here is that we have interest payable because we haven't paid it yet till january 1st. Obviously on january 1st 2019. So the next day we're gonna make an entry to debit interest payable And credit cash. Right? Because we're actually gonna make that payment and that's gonna be in the amount of 2250. Right, Okay. And that's very similar to what we saw in face value bonds. We're going to pay off the cash and get rid of the liability for interest payable. Okay so that's about it for this entry very similar to the entry we made on the previous page. Let's go ahead and see what happens when we repay the principal.

Alright, so now we finally reached the maturity date, we're gonna be making those journal entries just like we did for interest expense over the life of the bond, we're gonna keep making those same journal entries every year. So if you can think about it, our discount on bonds payable. If we look at the discount on bonds payable, remember it's been 10 periods that have passed. Now we finally reached the maturity date. So we started at 3000 as a debit balance and we kept making 300 credits to the account with every interest payment. And we did that 10 times 300 times 10. Well that's 3000. Right? So we've reached a point where there's no balance left in the discount on bonds payable, all of the discount has been advertised to interest expense over the five years, right? Because we would have kept making those same interest expense journal entries and advertising 300 300 310 times over the 10 interest payments. Okay, so there's no more discount on bonds payable. All that's left is our liability of bonds payable of 50,000. So now once we've reached the maturity date It makes sense. Our balance sheet shows hey you owe $50,000 and that's exactly what we owe right now. Right, the $50,000 that we're gonna pay off because the discount is gone, remember when I was showing you before we were showing bonds payable, that always has the entire principal value in it. 50,000. And we had less discount. Well guess what? After we've gotten rid of the discount, there's no discount left at this point. We've we've advertised it to interest expense over the life of the bond. So our bonds payable is showing a value of 50,000 and that's what we're going to pay off. Right now. We're going to debit bonds payable for 50,000 on the maturity date And that gets rid of the liability, right? We had a credit balance of 50,000 and now we're debating it 50,000, it's gone. And how do we get rid of it by paying off the principal in cash for 50,000. So now we've paid off the full 50,000 principle in cash. Remember even though we raised 47,000 when we offered the bonds, we still have to pay the full 50,000 upon maturity. Okay, that's the big deal here, is that you you pay off the face value of the bonds regardless of the amount of money that you raised initially. Cool. Alright. So in this case our cash has decreased by 50,000 And our liabilities decreased by 50,000 as well. Alright, so this stays balanced and we're good here. This is always the easiest journal entry because all we gotta do is get rid of the face value that's sitting on our books and we get rid of the cash. That's how we paid for it. Cool. Let's go ahead and do a practice problem before we move on to premium on the bonds payable