Definition: A discount on bonds payable occurs when the bond’s par value is higher than the issue price or carrying value. The difference between these two numbers is considered the bond discount. In other words, a discount is the difference between the par value and the issue price when the issue price is lower than the par value. You can also think of it as the difference between the amount of money investors pay for a bond and the actual bond price.
What Does Discount on Bonds Payable Mean?
Bonds often take companies months to construct and line up the proper legal structures before they are actually sold to the public. This means that the bond terms like interest, payback period, and principle amount are set months in advance before they are issued to the public.
This would be fine except that the bond market fluctuates everyday just like the stock market. Depending on the current market, investors might be unwilling to earn the interest rates that the bond states. This means that companies can’t issue bonds at the same price that is stated on the bond itself. An adjustment must be made in order to adjust the stated rate of interest to match the current market rate.
Bond issuers do this by creating a discount or lowering the selling price of the bond. When the market rate of interest is higher than the stated bond rate, the price of the bond must be lowered to equal the difference. This drop in price is referred to as the bond discount.
Example
For example, assume a company wants to issue a $1,000, 10% bond to the public when the market rate of interest is 12 percent. What kind of investor would buy this bond? No one would, so the company drops the initial selling price lower than $1,000. This way the investors will actually make 12% on their investment.
