Accounting for Bonds Payable and the Effective Interest Method
By SimplyCPA · 11 October 2026
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- Issue price: The present value of the principal plus the present value of the interest payments, discounted at the market rate.
- Discount or premium: Coupon rate below the market rate means a discount; above means a premium.
- Effective interest method: Interest expense = carrying amount × market rate. The difference from the cash coupon is the amortisation.
- Carrying amount: Moves towards face value each period — up for a discount, down for a premium.
- Issue costs: Shown as a direct deduction from the bond's carrying amount and amortised as interest expense.
Pricing a bond
A bond promises two cash flows: periodic interest at the coupon (stated) rate, and the principal at maturity. Investors discount those cash flows at the market (effective) rate for similar risk. So:
Issue price = PV of principal + PV of interest payments, both at the market rate.
- Coupon rate < market rate → issued at a discount (price below face).
- Coupon rate > market rate → issued at a premium (price above face).
- Coupon rate = market rate → issued at face (par).
Worked example: a bond issued at a discount
On January 1, Year 1, a company issues a $100,000, 5-year bond with an 8% coupon paid annually on December 31. The market rate is 10%.
- PV of principal: $100,000 × 0.62092 (PV of $1, 5 periods, 10%) = $62,092
- PV of interest: $8,000 × 3.79079 (PV of an ordinary annuity, 5 periods, 10%) = $30,326
- Issue price = $92,418, a discount of $7,582
| Year | Cash paid (8%) | Interest expense (10% × opening carrying amount) | Discount amortised | Closing carrying amount |
|---|---|---|---|---|
| 1 | $8,000 | $9,242 | $1,242 | $93,660 |
| 2 | $8,000 | $9,366 | $1,366 | $95,026 |
| 3 | $8,000 | $9,503 | $1,503 | $96,529 |
| 4 | $8,000 | $9,653 | $1,653 | $98,182 |
| 5 | $8,000 | $9,818 | $1,818 | $100,000 |
(Year 5 is rounded so the carrying amount reaches exactly $100,000.)
Journal entries
At issue: Dr Cash $92,418; Dr Discount on bonds payable $7,582; Cr Bonds payable $100,000.
December 31, Year 1: Dr Interest expense $9,242; Cr Discount on bonds payable $1,242; Cr Cash $8,000.
At maturity: Dr Bonds payable $100,000; Cr Cash $100,000.
Why the effective interest method
ASC 835-30 requires the interest method, because it produces a constant rate of interest on the carrying amount. The straight-line method — equal amortisation each year — may be used only if the results are not materially different.
Other rules worth knowing
- Bonds issued between interest dates: the buyer pays accrued interest since the last payment date, which the issuer refunds on the next coupon.
- Debt issue costs: presented as a direct deduction from the carrying amount of the debt (like a discount) and amortised as interest expense.
- Early extinguishment: the difference between the reacquisition price and the net carrying amount is a gain or loss in income from continuing operations.
- Fair value option: an entity may elect to measure the bond at fair value; changes from instrument-specific credit risk go to other comprehensive income.
- Convertible debt: under ASU 2020-06, most convertible debt is accounted for as a single liability, without separating a conversion feature.
Exam shortcut: For a discount, interest expense is always more than cash paid, and rises each year. For a premium, interest expense is less than cash paid, and falls each year. If your schedule doesn't do this, you've used the wrong rate.
Practise more in our FAR long-term debt notes.