A discount on bonds payable:
Increases the Bond Payable account
Occurs when a company issues bonds with a contract rate more than the market rate
Decreases the total bond interest expense
Occurs when a company issues bonds with a contract rate less than the market rate
Is not allowed in many states to protect creditors
The Correct Answer and Explanation is :
Correct Answer:
Occurs when a company issues bonds with a contract rate less than the market rate.
Explanation:
A discount on bonds payable happens when a company issues bonds at a price lower than their face (par) value. This occurs when the stated (contract) interest rate on the bonds is lower than the market interest rate at the time of issuance. Investors will not be willing to buy bonds with a lower-than-market interest rate unless they receive some form of compensation, which comes in the form of a discount.
For example, if a company issues a $1,000 bond with a 5% coupon rate while the prevailing market interest rate is 7%, investors will not be willing to buy the bond at its full face value because they can get a better return elsewhere. To attract buyers, the company will have to sell the bond at a discount, such as $950 instead of $1,000.
The discount on bonds payable is recorded as a contra-liability account in the company’s financial statements. Over the life of the bond, this discount is amortized as additional interest expense, which means that the total interest expense recognized on the company’s income statement will be higher than the cash interest payments made to bondholders.
Since the discount increases the cost of borrowing, the company ends up paying more in effective interest than what the stated rate suggests. This is why the correct answer is that a discount occurs when the contract rate is lower than the market rate.
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