Bonds and effective financing cost

Learning goals

• Explain face value, stated rate, market yield, issue price, and maturity.
• Record a bond issued at face and its interest payment.
• Interpret a discount or premium and calculate first-period effective interest.
• Compare bond financing with notes, loans, and shares.

Prerequisite check

Bond cash interest is based on face value × stated rate. Investors price the bond using the market yield for comparable risk and timing. Those rates answer different questions.

Vocabulary

• Bond: formal debt security issued to investors.
• Face value: principal repaid at maturity.
• Stated/coupon rate: rate determining contractual cash interest.
• Market/effective yield: return investors require at issuance.
• Discount: issue price below face when market yield exceeds stated rate.
• Premium: issue price above face when stated rate exceeds market yield.

Core idea

A bond's issue price is the present value of promised cash flows at the market yield. At face, stated and market rates match. A discount raises effective interest above cash paid; a premium lowers it. Both carrying amounts move toward face value by maturity.

Why this treatment makes sense

Investors will not pay face value for below-market cash interest without a price discount. Effective interest measures financing cost using the amount actually borrowed, while the coupon controls only periodic cash paid.

A repeatable method

1. Map face value, dates, stated rate, payment frequency, term, and market yield.
2. Calculate each cash coupon from face value.
3. Present-value coupons and principal at the market yield per period.
4. Record cash received and the bond liability at issue price.
5. Calculate effective interest = opening carrying amount × market rate per period.
6. Difference between effective interest and cash coupon changes carrying amount.
7. Check that carrying amount reaches face value at maturity, allowing final rounding.

Worked example

At face: Sudbury Transit Tech issues $200,000, 5% bonds when the market yield is 5%. Debit Cash $200,000; credit Bonds Payable $200,000. Semiannual cash interest is $200,000 × 5% × 6/12 = $5,000: debit Interest Expense and credit Cash $5,000.

Discount case: a $100,000, five-year bond pays 6% annually when market yield is 8%. Given present-value factors at 8% for five periods—annuity 3.99271 and single sum 0.68058—issue price is:

$6,000 × 3.99271 + $100,000 × 0.68058 = $92,014.26.

At issue, debit Cash $92,014.26 and credit Bonds Payable $92,014.26. First-year effective interest is $92,014.26 × 8% = $7,361.14. Cash coupon is $6,000, so the carrying amount grows by $1,361.14:

Table: First-year effective-interest entry for a discount bond

Ending carrying amount is $93,375.40.

Journal, ledger, and statement connection

The statement of financial position reports the amortized carrying amount, with current classification/disclosure based on maturity and terms. Interest expense lowers profit; coupon cash is an interest cash flow under the entity's applicable classification policy; issue and principal repayment are financing cash flows.

Common mistakes

• Calculating cash coupon using market yield.
• Recording discount as an immediate loss.
• Leaving a discount bond at its original carrying amount until maturity.
• Assuming a premium is revenue.
• Comparing only stated rates while ignoring issue price, fees, covenants, security, and market risk.

Guided practice

A $50,000 bond issued at $48,000 pays $2,500 cash annually; market yield is 7%. First-year effective interest is $3,360. Carrying amount increases $860 to $48,860. Entry: debit Interest Expense $3,360; credit Cash $2,500 and Bonds Payable $860.

Independent practice

1. Calculate semiannual coupon on $300,000, 4% bonds.
2. A premium bond has opening carrying amount $104,000, market yield 5%, annual cash coupon $6,000. Calculate expense and carrying-amount change.
3. Explain why a 4% bond can cost more than 4% to the issuer.

Self-check and solutions

1. $300,000 × 4% × 1/2 = $6,000.
2. Effective interest $5,200; cash $6,000; carrying amount decreases $800 to $103,200.
3. If issued below face, the issuer receives less cash but still repays face and coupons; market yield/effective interest captures that additional cost.

Retrieval practice

1. Which rate determines cash coupon?
2. Which rate determines issue price and interest expense?
3. Where does a discount carrying amount move over time?

Answers: stated rate; market/effective yield; upward toward face value.

Exam-style application

Company X offers a 7% stated bond at a premium; Company Y offers 5% at a discount. Can you identify the cheaper financing from stated rates alone?

Model response: No. Compare effective yields, issue proceeds net of fees, term, security, covenants, call features, repayment timing, and risk. Coupon rates alone do not measure the issuer's effective financing cost.

Lesson summary

Bond price converts promised cash flows into today's market value. Keep stated-rate cash separate from market-yield expense and move discount or premium carrying amount toward face.