Valuing Bonds Payable
A company can issue bonds either at face value (also known as par value), which is the principal amount printed on the bond; at a discount, which is less than face value; or at a premium, which means the bond sells for more than its face value. Usually face value is set in denominations of $1,000.
Premiums, discounts, and yields
To understand the value placed on a bond, you need to know the relationship between bonds prices and yield to maturity. Yield to maturity can be thought of as an investor’s total return on a bond. The total return has two components:
Interest income earned on the bond.
If the bond is purchased at a discount, the investor is paid the face amount at maturity. The difference between the discount and the face amount is a gain. The gain adds to the total return on the bond. A bond purchased at premium results in a loss when the investor is paid the face amount. The loss reduces the investor’s total return on the bond.
The effective interest rate
Generally accepted accounting principles (GAAP) prefers the effective interest method when accounting for bonds issued at a discount or a premium. When using the effective interest method, you amortize by using the carrying value of the bonds, which is face amount plus unamortized premium or minus unamortized discount.
You see the effective interest method used to amortize the no-face, no-interest note payable. In that instance, the discount represents the interest earned by the lender over time. Check out the following figure.
The carrying amount started as the cash received by the issuer when the note payable was issued. That amount can also be stated as the face amount less the unamortized discount, or $20,000 – $6,388 = $13,612.
Over time, the carrying amount is increased by the discount amortization each year. At the note’s maturity, the carrying amount is equal to the face amount, $20,000. If you’re the borrower, the amortization of the discount generates more interest expense to you. For the investor, amortization of the discount generates more interest income. In either case, amortization increases the carrying amount until it equals the face amount.
GAAP allows the straight-line method if the result is materially the same: straight-line method versus effective interest rate method. Keep in mind that International Financial Accounting Standards (IFRS) requires use of the effective interest method.