Journal Entry for Bond Purchased at Discount
When a bond is purchased at a discount, the buyer pays less than the face value of the bond. The difference between the purchase price and the face value is called the bond discount.
If a bond has a face value of $1,000 and is purchased for $950, the discount is $50. Discount bonds are commonly issued by corporations that have lower credit ratings. By offering a discount, these companies are able to catch the investors’ interest despite their higher risk of default.
Discount bonds typically have longer terms than other types of bonds, which further increases the risk for investors. However, they also offer higher yields than other bonds, which can make them attractive to some investors. Before investing in a discount bond, it is important to carefully consider the risks and rewards in order to make an informed decision.
A bond is a debt security, typically issued by a government or corporation, that pays periodic interest payments and pays the face value of the bond at the maturity date. Bonds are debt instruments used by corporations and governments to borrow money from investors. The issuer of the bond (the borrower) promises to make regular interest payments to the bondholders (the lenders) and to repay the principal amount of the loan (the face value of the bond) when it matures. Bonds are issued for various terms, ranging from a few months to 30 years. Some bonds are even callable, meaning that the issuer has the right to repay the bond before it matures.
Bonds are an important part of the financial markets and are used by individuals, institutions, and governments. For example, corporations use bonds to finance expansion projects or other capital expenditures, while governments use them to finance infrastructure projects or cover budget deficits. Individual investors can purchase bonds directly from issuers or through broker-dealers. Institutions such as banks and insurance companies also invest in bonds to earn income and diversify their portfolios.
The yield on a bond is the interest rate that the bond pays divided by the price of the bond. The price of a bond is determined by its coupon rate, its maturity date, and prevailing interest rates. When interest rates decline, bond prices rise, and vice versa. As a result, bonds can be used as a hedge against changes in interest rates.
Journal Entry for Bond Purchased at Discount
When the company purchases the bonds at discount, they have to record cash outflow and the investment in bonds. The journal entry is debiting investments in bonds and credit cash.
| Account | Debit | Credit |
|---|---|---|
| Investment in Bond | 000 | |
| Cash | 000 |
The transaction will increase the investment account on the balance sheet and reduce the cash amount.
When the bonds are sold at a discount, the company will receive a cheaper price compared to the par value. It happens when the bonds generate an annual interest income lower than the market rate. The bond rate is lower than the market rate. The issuer has to discount the bonds to attract investors. and they promise to pay back the full amount which equals face value.
The investors pay less than the bond’s face value, and they receive the full amount on the maturity date. There is a difference between the invested amount and the received amount. The bond’s investment account will increase every year to reach the bond’s par value.
At each year’s end, the company has to record cash received from bonds issuer and interest income. However, both figures will not be the same. The cash received will equal to bond’s face value multiplied by the coupon rate.
The interest income will be equal to the amount invest multiply by the market rate. The cash received will be lower than the interest income. It happens because bond rate is lower than the market rate which is the reason that bonds are sold at a discount. The difference between cash received and interest income will increase the investment in bonds to reach the face value at the maturity date. The journal entry is debiting cash received, investment in bond, and interest income.
| Account | Debit | Credit |
|---|---|---|
| Investment in Bonds | 000 | |
| Cash | 000 | |
| Interest income | 000 |
Journal Entry for Bond Purchased at Discount Example
ABC has purchased 100 bonds from a company. The bonds have par value of $ 1,000 with a coupon rate 8% over the term of 3 years. The interest rate on the market is 10%, The issuer has to discount the bond value to $ 950.26 to attract investors.
When ABC purchase 100 bonds from the issuer, they have to pay cash and record new investment.
The cash paid = 100 bonds x $ 950.26 /bond = $ 95,026
The journal entry is debiting investment in bonds $ 95,026 and credit cash for the same amount.
| Account | Debit | Credit |
|---|---|---|
| Investment in Bond | 95,026 | |
| Cash | 95,026 |
Due to the discount, ABC can spend only $ 95,026 and expect to receive the full $ 100,000 on the maturity date. At the end of first year, the issuer has to pay the interest base on the bond’s term. it is the amount that ABC going to receive.
Cash received = 100 bonds x $ 1,000 x 8% = $ 8,000
However, ABC needs to calculate the interest income base on the market rate and amount invested.
Interest income = $ 95,026 x 10% = $ 9,502.6
The difference will increase the investment in bonds.
Journal entry:
| Account | Debit | Credit |
|---|---|---|
| Investment in Bonds | 1,502.6 | |
| Cash | 8,000 | |
| Interest income | 9,502.6 |
At the end of second year, ABC will receive the same amount from bonds issuer. However, the interest income will change as the investment account increases.
Interest income = (95,026 + 1,502.6) x 10% = $ 9,652.86
Similar to last year, the journal entry will be:
| Account | Debit | Credit |
|---|---|---|
| Investment in Bonds | 1,652.86 | |
| Cash | 8,000 | |
| Interest income | 9,652.86 |
At the end of third year, the cash still the same, only the interest income will increase.
Interest income = (95,026 + 1,502.6 + 1,652.86) x 10% = $ 9,818.14
| Account | Debit | Credit |
|---|---|---|
| Investment in Bonds | 1,818.14 | |
| Cash | 8,000 | |
| Interest income | 9,818.14 |
By the end of the bond term (3 years), investment in bonds account has increased to $ 100,000 (95,026 + 1,502.6 + 1,652.86 + 1,818.14). So when the issuer pays back the face value, ABC simply records cash and investment in bonds. The journal entry is debiting cash of $ 100,000 and credit investment in bonds of $ 100,000.
| Account | Debit | Credit |
|---|---|---|
| Cash | 100,000 | |
| Investment in Bonds | 100,000 |
Why Company Invested in Bonds?
Companies invest in bonds for various reasons, with several key factors contributing to their decision-making process:
- Higher Returns: Bonds offer the potential for higher returns compared to traditional money market funds and bank accounts. When a company invests in bonds, it lends money to the bond issuer (such as a government or corporation) in exchange for periodic interest payments and the return of the principal amount at maturity. The interest rates on bonds can be more attractive than those offered by other short-term investment options, providing the potential for enhanced returns on the company’s invested capital.
- Diversification: Bonds provide a valuable tool for diversification within a company’s investment portfolio. By investing in a mix of bonds with different risk profiles, maturities, and issuers, companies can spread their investment risk. This diversification helps mitigate the impact of adverse market conditions affecting a particular bond or sector, enhancing the overall stability of the investment portfolio.
- Professional Management: Investing in bonds often involves complex analyses of interest rate trends, credit risk, and market conditions. Companies may lack the specialized knowledge or resources required to effectively manage a bond portfolio. By investing in bond funds managed by professional portfolio managers, companies can benefit from expert handling of maturity dates, interest rate movements, and bond trading strategies. This professional management aims to optimize returns while actively monitoring and adjusting the portfolio to align with market conditions.
- Convenience: Bonds offer a convenient one-stop solution for companies seeking diversification and exposure to various fixed-income securities. Instead of individually selecting and managing a range of bonds, companies can invest in bond funds that pool resources from multiple investors to create a diversified portfolio. This approach saves time and effort, making it a more convenient option for companies that may not have dedicated investment teams or the expertise to actively manage a broad array of fixed-income assets.
