Bonds payable are long-term liabilities a company records when it borrows by issuing bonds. A bond sells at par when its stated rate equals the market rate. It sells at a discount when the stated rate is lower. It sells at a premium when the stated rate is higher. The discount or premium is then amortized with the effective interest method, which sets interest expense each period. These bonds payable CPA notes explain the method with full journal entries and a worked example.
For example, block two short sessions for this topic in the study timetable generator and schedule your FAR revision before you move on. Above all, work the numbers yourself at least once. That practice will lock in the method far better than rereading will.
Bonds payable CPA notes: why bonds sell at par, discount, or premium
Bonds payable are long-term liabilities a company records when it issues bonds. The account carries face value, but cash received is the issue price. If the stated rate differs from the market rate, bonds sell at a discount or premium, and the difference is amortized using the effective interest method over the bond term.
A bond has two interest rates. However, the tension between those two rates decides the issue price. Understanding that tension is the whole topic in miniature.
- Stated (coupon) rate: This rate is printed on the bond. It decides the actual cash paid each period: face value multiplied by the stated rate.
- Market (effective, yield) rate: This rate is what investors can earn on similar bonds right now. It decides what investors will pay for your bond.
If the two rates are equal, investors pay exactly face value. In that case, the bond issues at par. In contrast, if your stated rate is below the market rate, investors will not pay full price for weaker coupons. Therefore, the bond sells at a discount.
Meanwhile, if your stated rate beats the market rate, investors bid the price up. As a result, the bond sells at a premium. For example, a generous coupon is worth more than face value to a buyer.
However, the discount or premium is not a loss or a gain. It is deferred interest. In other words, it is an adjustment that pushes your true borrowing cost to the market rate. Above all, that single idea drives everything below.
Bonds payable CPA notes: the effective interest method
US GAAP requires the effective interest method. However, straight-line amortization is allowed only if the result is not materially different. Therefore, the exam default is always the effective interest method. You compute three numbers every period:
- Interest expense = beginning carrying value multiplied by the market rate. The market rate is the rate at issuance, and it stays locked in for the life of the bond.
- Cash interest = face value multiplied by the stated rate. This amount stays constant every period.
- Amortization depends on the case. For a discount, amortization = interest expense minus cash interest. For a premium, amortization = cash interest minus interest expense.
With a discount, expense exceeds cash. Therefore, you credit the amortization to the discount account. As a result, carrying value rises toward face value over time.
With a premium, cash exceeds expense. In contrast, you debit the amortization to the premium account. As a result, carrying value falls toward face value over time. At maturity, carrying value always equals face value. Meanwhile, the discount or premium is fully amortized by that date.
Most exam bonds, however, pay interest semiannually instead of annually. In that case, halve both rates and double the periods before you compute anything. A 5-year semiannual bond has 10 periods, and each period uses half the stated rate and half the market rate. The three formulas stay identical after that adjustment.
Bonds payable CPA notes: worked example, bonds issued at a discount
A company issues $100,000 face value bonds with an 8% stated rate and a 5-year term. The bonds pay interest annually. However, the market rate at issuance is 10%. Because the stated rate of 8% is below the market rate of 10%, the bonds sell at a discount.
You price the bond with present value. Issue price = present value of principal plus present value of the interest annuity, both discounted at 10%:
- Present value of $100,000 in 5 years: $100,000 x 0.62092 = $62,092
- Present value of $8,000 annual interest: $8,000 x 3.79079 = $30,326
- Issue price = $92,418; discount = $7,582
For example, the same present-value logic prices leases, so review the FAR lease accounting notes under ASC 842 after this topic. That connection will help you in two FAR areas at once.
At issuance, record the entry as follows:
- Dr Cash 92,418
- Dr Discount on Bonds Payable 7,582
- Cr Bonds Payable 100,000
Next, record Year 1 interest. Each number comes straight from the formula set above:
- Interest expense = $92,418 x 10% = $9,242
- Cash interest = $100,000 x 8% = $8,000
- Discount amortization = $9,242 minus $8,000 = $1,242
- Dr Interest Expense 9,242
- Cr Discount on Bonds Payable 1,242
- Cr Cash 8,000
Therefore, the new carrying value = $92,418 + $1,242 = $93,660. Year 2 expense = $93,660 x 10% = $9,366, and Year 2 amortization is $1,366. As a result, the pattern continues in the same way each year.
Notice the pattern as you work. Interest expense rises each year as carrying value climbs. For a premium bond, however, the mirror image holds. Expense falls each year as carrying value declines toward face value.
Premium mirror: the same bonds when the market rate is 8%
Now flip the two rates. The company issues the same $100,000 face value bonds, this time with a 10% stated rate, and the market rate is 8%. Because the stated rate beats the market rate, the bonds sell at a premium.
- Present value of $100,000 in 5 years at 8%: $100,000 x 0.68058 = $68,058
- Present value of $10,000 annual interest at 8%: $10,000 x 3.99271 = $39,927
- Issue price = $107,985; premium = $7,985
At issuance, record the entry as follows:
- Dr Cash 107,985
- Cr Premium on Bonds Payable 7,985
- Cr Bonds Payable 100,000
Next, record Year 1 interest:
- Interest expense = $107,985 x 8% = $8,639
- Cash interest = $100,000 x 10% = $10,000
- Premium amortization = $10,000 minus $8,639 = $1,361
- Dr Interest Expense 8,639
- Dr Premium on Bonds Payable 1,361
- Cr Cash 10,000
Therefore, the new carrying value = $107,985 minus $1,361 = $106,624. Expense then falls each year as carrying value declines, exactly the mirror image of the discount case.
Finally, the maturity entry closes the topic. By the maturity date, amortization has brought the carrying value to exactly $100,000. The issuer records the final interest payment first. After that, the issuer debits Bonds Payable 100,000 and credits Cash 100,000. No gain or loss arises when bonds mature on schedule.
Bond issue costs: the contra-liability rule
Underwriting, legal, and printing fees cost real money at issuance. In the past, those fees sat on the balance sheet as a deferred asset. However, ASU 2015-03 changed that treatment. The FASB issued ASU 2015-03 on April 7, 2015. It is effective for fiscal years beginning after December 15, 2015.
Under the current rule, debt issuance costs are presented as a direct deduction from the carrying amount of the debt liability. In other words, issue costs work exactly like a discount. Therefore, present them as a contra-liability, not as an asset.
You amortize issue costs into interest expense over the life of the bond using the effective interest method. However, straight-line amortization is used only when the results are not materially different. Meanwhile, any unamortized balance is written off if the debt is retired early. As a result, early retirement always clears the remaining issue costs.
Exam Traps
Exam trap: the answer “debit an asset for bond issue costs” reflects the pre-ASU treatment (before 2016) for bonds and other term debt. The current rule is contra-liability. However, the exam still dangles the old answer. Therefore, reject any choice that records issue costs as an asset.
Exam trap: interest expense always uses the effective rate locked in at issuance. You compute that expense on the net carrying amount. In other words, you take issue costs, discount, and premium in aggregate when you find that amount. However, later market-rate moves do not change the expense. Students who recompute with a new rate get every subsequent number wrong.
Exam trap: on early retirement, gain or loss = net carrying amount minus reacquisition price. Net carrying amount = face value plus unamortized premium, minus unamortized discount and unamortized issue costs. However, you first amortize the unamortized balances up to the retirement date. Forgetting to include the unamortized discount or premium is the classic error. As a result, many candidates misstate the gain or loss.
Exam trap: semiannual bonds need semiannual numbers. Halve the stated rate, halve the market rate, and double the periods. Candidates who price a semiannual bond with annual rates get the issue price wrong. After that, every later entry inherits the error.
One-Page Revision
- Stated rate drives the cash coupons: face value multiplied by the stated rate. The market rate drives pricing and expense.
- Stated below market: discount. Stated above market: premium. Equal rates: par.
- Interest expense = carrying value multiplied by the market rate at issuance. Cash interest = face value multiplied by the stated rate. Amortization = the difference, signed by the case: for a discount, amortization = interest expense minus cash interest; for a premium, amortization = cash interest minus interest expense.
- Discount: expense exceeds cash, and carrying value rises to face. Premium: expense is below cash, and carrying value falls to face.
- Issue costs (ASU 2015-03): contra-liability, amortized to interest expense over the life of the bond.
- Semiannual payments: halve both rates and double the periods, then use the same three formulas.
- At maturity: carrying value equals face value. Debit Bonds Payable and credit Cash for the face amount.
FAQ
Can a company use straight-line amortization for bond discount?
Only if the results are not materially different from the effective interest method. Therefore, the exam default is effective interest. Use straight-line only when the question says otherwise.
Where does the premium or discount appear on the balance sheet?
Present the premium as an addition to Bonds Payable and the discount as a deduction from Bonds Payable. The statement shows a single net carrying amount in long-term liabilities. However, a bond, or the portion of it, due within one year (or the operating cycle) is a current liability. Therefore, classify that portion with current liabilities instead.
What if bonds are issued between interest dates?
The buyer pays accrued interest from the last interest date to the purchase date. At issuance, the issuer credits that accrued amount to Interest Payable, not to income. At the first coupon date, the issuer debits Interest Payable for the accrued portion. The issuer records Interest Expense only for the period the bonds were actually outstanding, and credits Cash for the full coupon. As a result, the accrued piece is a wash for interest expense. However, the exam tests these cash mechanics and the Interest Payable account, so learn them well.
Above all, keep drilling the formula set until the entries feel automatic. Meanwhile, you will find more FAR topics in our CPA notes collection. Each note follows the same worked-example approach.
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Daniel Mercer is a finance professional writing on professional exams, study strategies, and finance careers.
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