🧾financial accounting i review

key term - Bond discount

Definition

A bond discount occurs when a bond is issued or sold for less than its face value, typically because its stated interest rate is lower than the current market interest rates. This situation means investors can purchase the bond at a lower price, providing them with an opportunity to earn a higher yield compared to the bond’s coupon rate. The bond discount represents a form of interest expense that will be amortized over the life of the bond until it matures.

5 Must Know Facts For Your Next Test

  1. Bonds are often issued at a discount when prevailing market interest rates rise above the bond's coupon rate, making existing bonds less attractive.
  2. The bond discount increases the effective yield for investors, allowing them to earn more interest relative to their initial investment.
  3. When accounting for bonds issued at a discount, the issuer must record both the cash received and the discount as a liability on their balance sheet.
  4. The amortization of the bond discount affects the interest expense reported in financial statements, increasing it over time until maturity.
  5. At maturity, the carrying value of the bond equals its face value, meaning any remaining discount has been fully amortized.

Review Questions

  • How does issuing a bond at a discount impact the financial statements of an issuer?
    • When a bond is issued at a discount, the issuer must record the cash received and also recognize the discount as a liability. Over time, this discount is amortized, which increases interest expense in the income statement. This leads to a higher overall cost of borrowing for the issuer compared to if they had issued the bond at face value. Consequently, it affects net income and cash flow from operations.
  • In what ways does the market interest rate influence whether bonds are sold at a discount or premium?
    • Market interest rates play a crucial role in determining whether bonds are sold at a discount or premium. If current market rates rise above a bond's coupon rate, the bond becomes less attractive, leading to it being sold at a discount. Conversely, if market rates fall below the coupon rate, the bond may sell at a premium. This reflects investors' willingness to pay more or less based on relative yields in the market.
  • Evaluate how the amortization of a bond discount affects both an investor's return and an issuer's reporting over the life of the bond.
    • The amortization of a bond discount impacts an investor's return by increasing their effective yield as they benefit from both periodic interest payments and capital gains upon maturity. For issuers, this amortization increases reported interest expenses over time, affecting profitability and financial ratios. This ongoing adjustment ensures that by maturity, the carrying amount of the bond equals its face value, accurately reflecting its financial position throughout its life.