What I would like to know is why do you subtract the discount from the interest expense. How does the discount correlate with interest expense?
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Bond interest expense is the interest payments that a bond issuer makes to the bond holders. In order to raise financing or capital, a company, municipality, state, county or federal government may issue a bond. Investors buy the bond, which contributes the money the entity uses for its capital needs. In return, the bond buyers earn interest. This interest is an expense to the entity that sold the bond.
In other words, when a company issues bonds, it is acting as a borrower. When an individual or investor buys bonds, they are acting as the lenders. Just as any borrower is required to pay interest on a loan, in this case, the government agency or company borrowing the money is required to pay a bond interest expense.
Companies, government agencies or the issuer of the bonds record bond interest payments on the balance sheet of the accounting records. How the bond interest expense is recorded depends on how the bonds were initially issued. The bond issuance options include at face value, at a discount or at a premium.
When a bond is sold to investors at face value, the buyer of the bond pays the price that the bond is worth. For example, with a 5-year bond for $100,000 US Dollars (USD) that carries an interest rate of 10%, the buyer of the bond pays face value. The company records the issuance of the bond in the liability section of the balance sheet. The company debits the interest expense for the 10% interest payment and credits the accrued interest payable for the same $10,000 USD bond interest expense. When the company makes the interest payment, the accrued interest payable account is debited and the cash account is credited, both for the $10,000 USD.
When bonds are sold at a discount, then the buyer pays less than the face value of the bond. For example, a $10,000 USD bond with a 2% discount sells for $9,800 USD. The buyer, however, redeems the bond on its maturity date for the full face value of $10,000 USD. When companies record the sale of the bond, it debits the cash account for the discount value and credits the bonds payable account on the balance sheet for the same amount. To indicate the discount price, record the discount by debiting the bond interest expense, $2,000 USD, and crediting the bond discount for the same amount in the liability section of the balance sheet.
When bonds are sold at a discount, the bond interest expense is amortized over the life of the bond. For example, a 5-year bond would amortize the interest expense over a five year period. If the interest payment is $2,000 USD, then $400 USD per year would be allocated to the interest expense. To indicate this, the company debits the bond discount and credits the bonds payable accounts on the balance sheet for the amortized amount for that year, $400 USD. The company then records the bond interest expense in the same way as when a bond is redeemed at face value.
When bonds sell at a premium, then the investor pays more than the face value of the bond. In this case, a 2% premium means the investor pays $102,000 USD for a bond selling at a premium with a face value of $100,000 USD. Companies record the sale of the bond by recording a debit in the cash account and a credit in the bonds payable account of the balance sheet. The interest expense is also amortized over the life of the bond.
With premium bonds, the sale of the bond is deducted from the bonds payable account and added to the bond interest expense account of the balance sheet. When the bond matures, the investor claims the face value of the bond. The company then records the interest expense in the same way as when a bond is redeemed at face value.