Bond Discount: Accounting and Tax Implications
Understand how a bond discount aligns a bond's yield with market rates and the required accounting and tax treatments for issuers and investors.
A bond is a form of debt issued by entities like corporations and governments to raise capital. Investors who purchase these bonds are lending money to the issuer, who in return promises periodic interest (coupon) payments and repayment of the principal (face value) at maturity. A bond discount occurs when a bond is issued for an amount less than its face value. This discount serves to align the bond’s return with that of comparable investments available in the market based on prevailing interest rates.
Causes of a Bond Discount
A bond is issued at a discount when its fixed interest rate, or coupon rate, is lower than the prevailing market interest rates for similar bonds. If a newly issued bond offers a lower interest payment than other available investments, it is less attractive. To entice investors, the issuer must sell the bond for less than its face value. This price reduction compensates the investor for the lower coupon payments.
The relationship between a bond’s price and market interest rates is inverse. When market interest rates rise, new bonds will offer higher coupon rates. Consequently, existing bonds with lower fixed coupon rates become less valuable, and their market price must decrease to a discount to offer a competitive yield. An investor would not pay full price for a bond yielding 4% when they could purchase a new, similar bond that yields 5%.
Consider a company that issues a five-year bond with a face value of $1,000 and a 4% annual coupon rate. If the market interest rate for comparable bonds is 5% on the day of issuance, investors will demand a return that matches this higher rate. To achieve this, the bond’s price must be lowered below $1,000. This discount ensures the total return aligns with the 5% market yield.
The size of the discount is influenced by the difference between the coupon rate and the market rate, and the time remaining until maturity. A larger gap between the rates or a longer time to maturity results in a deeper discount. The creditworthiness of the issuer also plays a role, as a lower credit rating may require a larger discount to attract investors.
Calculating Bond Discount and Yield
The bond discount is the difference between the bond’s face value (also called par value) and the price at which it was issued. For example, if a bond with a $1,000 face value is issued for $950, the bond discount is $50. This $50 represents a form of deferred interest that the investor will realize when the bond matures and they receive the full $1,000 face value.
A more comprehensive measure of an investor’s return is the Yield to Maturity (YTM). YTM represents the total annualized return an investor can anticipate if the bond is held until it matures. It is a more complete metric than the coupon rate because it accounts for the periodic interest payments and the gain from the bond discount. For a bond purchased at a discount, the YTM will always be higher than its coupon rate.
Calculating the precise YTM involves a complex formula that considers the bond’s current market price, par value, coupon interest rate, and time to maturity. It finds the discount rate that equates the present value of all future cash flows to the bond’s current price. While financial calculators or software are often used, an approximate YTM can be calculated to provide a reasonable estimate.
The approximation formula adds the annual coupon payment to the annualized discount and divides that sum by the average of the bond’s face value and its purchase price. For a $1,000 bond with a 5% coupon rate ($50 per year) purchased for $900 with 10 years to maturity, the annualized discount is $10. The approximate YTM would be roughly 6.3%, calculated as ($50 + $10) divided by the average price of $950.
Accounting for a Bond Discount
From the perspective of the issuing entity, a bond discount is treated as an additional cost of borrowing. This discount must be amortized, or systematically written off, as interest expense over the life of the bond. This process ensures the total interest expense recognized reflects the true cost of the debt, including both coupon payments and the discount.
Upon issuance, the company records the cash received, establishes a liability for the full face value of the bonds, and records the difference in a contra-liability account called “Discount on Bonds Payable.” For instance, if a company issues $100,000 of bonds for $93,000, the initial journal entry would show a debit to Cash for $93,000, a credit to Bonds Payable for $100,000, and a debit to Discount on Bonds Payable for $7,000. This discount account is presented on the balance sheet as a reduction from the bonds’ face value.
Two methods are available for amortizing the discount: the straight-line method and the effective interest method. The straight-line method is simpler, dividing the total discount equally over each interest period. However, Generally Accepted Accounting Principles (GAAP) require the effective interest method, which applies a constant interest rate to the bond’s changing carrying value, unless the results are not materially different.
Under the effective interest method, the interest expense for a period is calculated by multiplying the bond’s carrying value by the effective market interest rate. The difference between this calculated interest expense and the cash coupon payment is the amount of discount amortized for that period. This amortization increases the bond’s carrying value over time, so that it equals the face value at maturity. Each interest payment entry involves debiting Interest Expense, crediting the Discount on Bonds Payable, and crediting Cash.
Tax Treatment of a Bond Discount
For the bondholder, the tax implications of a bond discount depend on whether it is an Original Issue Discount (OID) or a market discount. OID occurs when a bond is first issued for a price less than its stated redemption price at maturity. The Internal Revenue Service (IRS) treats OID as a form of taxable interest that accrues over the life of the bond, regardless of whether cash payments are received.
This means investors must include a portion of the OID in their taxable income each year, a concept often called “phantom income” because taxes are due on income not yet received in cash. The issuer of the bond is required to report the amount of OID includible in the investor’s income for the year on Form 1099-OID.
The annual OID income reported also increases the investor’s cost basis in the bond. This adjustment is important because it reduces the amount of capital gain or increases the capital loss realized when the bond is sold or redeemed. For example, if an investor includes $20 of OID in income, their basis in the bond increases by $20, ensuring this amount is not taxed twice.
A market discount arises when an investor purchases a bond on the secondary market for a price lower than its stated redemption price. Unlike OID, the tax treatment for market discount offers more flexibility. The investor can elect to include the accrued discount in income annually or defer reporting the income until the bond is sold or matures. If deferred, the accrued market discount is taxed as ordinary interest income at the time of disposition, not as a capital gain.