Question

Consider this question:

Assume that your bond has an interest rate of 10 percent when other bonds are paying 12 percent. Investors will not want to buy your bond if they can earn 12 percent elsewhere. What can you do to get investors to buy your 10 percent bond? (Answer: lower the price)

You will need to drop the price of your bond so investors are really getting a 12 percent return. In other words, you need to drop the price to the present value of the bond using a 12 percent interest rate. You will need to sell the bond at a discount.

The selling price of a bond is determined by the relationship between the bond’s contract interest rate and the market interest rate when the bond is sold.

             If contract rate = market rate, bond sells at face value.

            If contract rate > market rate, bond sells at a premium.

            If contract rate < market rate, bond sells at a discount.

DEMONSTRATION PROBLEM 3 — Issuance of a Bond (Premium)

On January 1, a corporation issued a $1 million, five-year, 11 percent bond that pays interest semiannually. The market interest rate on January 1 was 10 percent. What would be the journal entry to record the issuance of this bond? (The market value of the bond, so you won’t have to calculate it yourself, is $1,038,606).  

Answer 1

• The concept regarding issuance of Bonds mentioned is correct.
• If the Bonds payable are issued at an interest rate that is LOWER than Market Interest rate, the bonds will be issued at a discount in order to make the investor interested in that security.
• Likewise, if Interest rate is HIGHER than market interest rate, the Bonds are issued at a Premium.
• Problem 3:

Face Value of Bonds = $ 1,000,000
Issue Price = $ 1,038,606

Premium on Bonds Payable = 1038606 – 1000000 = $ 38,606

Journal Entry would be:

Date	Accounts title	Debit	Credit
01-Jan	Cash	$                       1,038,606.00
	Premium on Bonds Payable		$               38,606.00
	Bonds Payable		$             100,000.00
	(Bonds issued)