Issuance of Bonds Payable at Premium

When the stated interest rate on a bond is higher than the prevailing market price a company is
able to sell its bonds for more than their par value. Investors consider the bond to be worth more
than its par because it is offering a rate of return that is higher than the market rate of return.

Example

Company P has printed 100,000 bonds of face value of $100 each, carrying a stated interest rate
of 10% and maturing in five year. When the company is ready to sell the bonds on 1 January 2013
the market rate is 8%. Since the stated interest rate is higher than the market interest rate the
bonds will be issued at a premium to the par value which means the price will be higher than the
par value.

The price would be $108 calculated as follows:

Price of Bond = 10% × $100 1 − (1 + 8%)-5 $100

+ = $108
×  8% (1 + 8%)5

Accounting treatment for issuance of bonds at premium

Company P will record this issue of bonds at a price higher than their par value using the following
journal entry:

Cash 108,000
Bonds Payable 100,000
Premium on Bonds Payable 8,000

The premium on bonds payable is added to the face value of bonds payable on the balance sheet
and increases the carrying amount of the bonds.

Interest expense on bonds issued at premium

The interest expense recognized on bonds issued at premium to par is the difference between the
interest paid or payable of $10,000 based on the stated interest rate of 10% (calculated as the
product of 10% and the face value of $100,000) and the annual amortization of premium on bonds
payable. If the premium is amortized based on a straight line method the premium of $8,000
would be written off over the 5 years of the bonds payable. Amortization of bond premium for the
year would be $1,600. Company P would record the annual interest expense as follows:

Interest Expense 8,400

Amortization of Premium 1,600
Interest Payable/Cash 10,000

The amortization of premium on bonds reduces the carrying amount of bonds such that at the
maturity the carrying amount of bonds payable approaches their face value.

Retirement of bonds issued at premium

At maturity the carrying amount of bonds payable issued at premium approaches their face value
and the bond is redeemed by paying back the principal to bondholders. Company P would record
the event as follows:

Bonds Payable 100,000

Cash 100,000

Issuance of Bonds Payable at Discount

A bond is issued at discount when it is sold for less than its par value. When the interest rate
stated on a bond is lower than the market interest rate the investor the investor consider the bond
to be overvalued because it is offering a less than market return. In order to induce the investors
to buy the bond the issuer is forced to reduce the price of the bond.

Example

Company D has printed 1,000 bonds of $100 par value having a maturity of 5 years and annual
coupon of $8 per year. When it was finally ready to issue the bond on 1 July 2012 the interest rate
prevailing in the market has soared to 10%.

Accounting treatment for issuance at discount

Inventors would not be willing to buy a bond for $100 because it is overvalued at 8%. The correct
value keeping in view the market interest rate of 10% is $92.42 calculated as follows:

Price of Bond = 8% × $100 1 − (1 + 10%)-5 $100

+ = $92.42
×  10% (1 + 10%)5

Company D would be able to raise only $92,420 from the bond with face value of $100,000. It has
issued them at a discount of $7,580 ($100,000 minus the proceeds of $92,420).

Company D will record the issuance by the following journal entry:

Cash 92,420
Discount on Bonds Payable 7,580
Bonds Payable 100,000

Bonds payable is reported on the balance sheet net of the discount i.e. 92,420 ($100,000 face
value less discount of $7,580).

Recognition of interest on bonds issued at discount

Interest expense in case of bonds issued at discount has two components: one related to the
payment of interest based on the coupon rate and second relates to amortization of discount.
Discount is amortized using either straight line method or the effective interest method.
In case of Company D interest paid in cash equals $8,000 ($100,000 multiplied by the stated
coupon rate of 8%). Assuming straight line amortization the yearly amortization expense should
be $1,516. Total interest expense is hence $9,516 which is recorded as follows:

Interest Expense 9,516

Interest Payable 8,000
Discount on Bonds Payable 1,516

Amortization of discount reduces the balance in the contra account to bonds payable and results in
an increase in carrying amount of bonds payable. Amortization reduces the balance in discount on
bonds payable account such that at the maturity the bonds payable's carrying amount is equal to
its face value.

Retirement of bonds issued at discount

At maturity the bonds' carrying amount is equal to their face value. Company D would pay off the
face value and record the event as follows:

Bonds Payable 100,000

Cash 100,000

Let’s explain this with a help of an example:

Let’s take the bond price as Rs.100 which pays a rate of interest called a coupon. Now, if the
interest rates go up, the bond, in order to pay the same rates, will have to cost less. So, the same
bond which was costing Rs.100 may be priced at Rs.90.

Now, let’s ignore the discount factor where the time frame of a bond is one year giving an interest
rate of 4% and having principle amount as Rs.100. According to 4% rate of interest, the investor
gets 4%*100= Rs.4. You pay Rs.100 for a bond today. At the end of year 1, you receive Rs.4. 
Now you can buy a new 1 year bond which pays 4.25% on Rs.100 bond. Thus, you tend to pay
less for a bond which will now pay 4.25 % as interest and was originally paying 4% interest.

Now the question is much less are you required to pay.

Today: You Pay X.

Year 1: You Receive Rs4.00 Year 1

(Maturity): You Receive Rs.100 The interest you receive + the difference between the redemption
price (Rs.100) and the initial price paid (X) should give you 4.25%:

[(Rs100 - X) + Rs4.00] / X = 4.25%

Rs.104 - X = 4.25% * X

Rs.104 = 4.25% * X + X

Rs.104 = X (4.25% + 1)

Rs.104 / (1.0425) = X

X = Rs 99.76 So, to get a 4.25% yield, you would pay Rs.99.75 for a bond with a 4% coupon.
 [Rs 4.00 - (RsX - 100)] / X = 3.5%

Rs. 104 - X = 3.5% * X

Rs.104 = X + 3.5% * X

Rs.104 = X (1 + 3.5%)

Rs.104 / (1.035) = X

X = Rs 100.48

Why Fed Tapering caused a rise in bond

yields
Readers Question Why did bond yields in the USA rise at news of the Fed Tapering
back in August?
The Federal Reserve has been engaged in a policy of quantitative easing. This involves:
 Creating money electronically
 Using this created money to buy assets, such as government bonds.
The aim of quantitative easing is to stimulate economic activity – increase economic
growth and avoid inflationary pressure. QE aims to stimulate economic growth through
increasing the money supply and reducing interest rates in the economy.

 When the Fed buys bonds, the greater demand pushes up the price of bonds.
 However, with an increase in the price of bonds, the bond yield falls.
 There is an explanation here why there is an inverse relationship between the price of
bonds and the yield of bonds.
With the Federal Reserve buying bonds, other investors are also keener to buy bonds.
The Fed is pushing up the price of bonds so whilst this is occurring other investors may
be encouraged to also buy bonds and benefit from the rising prices.

Fed Tapering
Fed Tapering means that the Federal Reserve will begin to stop buying bonds, and no
longer continue to create money and buy bonds. This tapering could also be seen as a
preliminary to reversing quantitative easing and selling the bonds that have been
accumulated.

A decision that the Fed would be beginning to end quantitative easing, will encourage
investors to start selling bonds.

If the Fed stops buying bonds, the price is likely to stop rising; and if quantitative easing
is reversed,  bond prices could fall. This expectation of falling bond prices will encourage
investors to sell. Markets are always trying to anticipate future movements. Therefore,
even a weak signal that bond purchases may start to be tapered was seen as a signal
that now would be a good time to sell bonds and move into something else.

As bond prices fell, the yield started to rise (the inverse relationship again)

Economic recovery and rising bond yields

Another factor to explain rising bond yields is that the Fed’s decision to Taper bond
purchases is related to the improved economic prospects. With stronger economic
growth, bond yields tend to rise. The reason is that economic growth encourages
investors to put money into more profitable private investment schemes. Government
bonds are in strong demand when the economy is in recession. They are seen as a safe
investment. In a recession corporate bonds are seen as more risky because firms may
go bankrupt in the recession. An economic recovery though will encourage investors to
sell the safer government bonds and buy riskier corporate bonds with potential for higher
yield. Therefore, a recovery tends to see lower price of government bond yields, and
rising yields.

Bond rates dropping -> Prices increasing -> demand for bonds high -> inflation low (as people
have less money and so invest in safer options such as bonds) -> RBI cuts rate to increase
inflation