Quick answer
A bond is a borrowing divided into standardized debt instruments. Its coupon determines cash interest, while its issue yield determines the financing cost reflected through the effective-interest method. A discount or premium makes the liability’s carrying amount move toward the amount repayable at maturity.
A company promises periodic interest payments and repayment of the bond’s face amount. Investors price those cash flows using the return they require. When that market return differs from the coupon rate, proceeds differ from face value.
Face amount, coupon, issue price, and yield
- Face amount is the principal repaid at maturity.
- Coupon rate determines contractual cash interest.
- Issue price is the proceeds before any separate transaction-cost analysis.
- Effective rate or yield allocates financing cost over the bond’s life for an amortized-cost liability.
When the coupon is below the market yield, investors ordinarily pay less than face value: a discount. When it is above the market yield, they ordinarily pay more: a premium.
Present value puts cash flows due on different future dates onto one issue-date basis. Each payment is divided by one plus the market yield for every year the investor must wait. A lower present value therefore reflects both the delayed receipt and the return the investor requires over that time.
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| Relationship | Issue price | Subsequent carrying amount |
|---|---|---|
| Coupon below market yield | Discount: below face amount | Rises toward face amount |
| Coupon equals market yield | Normally near face amount | Remains near face amount |
| Coupon above market yield | Premium: above face amount | Falls toward face amount |
Economic basis of the effective-interest method
A discount is part of the financing cost: the issuer must repay more principal than it received at issue. Effective interest allocates that difference over the borrowing term alongside the coupons. A premium has the opposite effect because the issuer initially receives more than the amount repayable.
Effective-interest mechanics
Interest expense equals the opening carrying amount multiplied by the effective rate because that opening amount represents the measured financing outstanding at the start of the period. Cash interest equals face amount multiplied by the coupon rate. Their difference changes the carrying amount. Use a rate and time interval that match the payment schedule: an annual rate cannot be applied unchanged to every half-year. For a discount, expense exceeds cash interest and the carrying amount rises; for a premium, cash interest exceeds expense and the carrying amount falls.
Amortize a two-year bond discount
Harbour Works issues a two-year, $100,000 bond for $96,333 on January 1, 2026. The bond pays $4,000 cash interest each December 31. Its effective annual yield is 6%. The rounded issue price equals the present value of the two coupons and maturity payment. The stated facts assume issue price equals initial fair value, exclude transaction costs, and classify the liability at amortized cost using the effective-interest method.
Issue price = $4,000 ÷ 1.06 + $104,000 ÷ 1.06² = $96,333
The first term discounts the 2026 coupon for one year. The second discounts the 2027 coupon and $100,000 maturity payment together for two years. The result is what those promised cash flows are worth at the 6% issue yield on January 1, 2026.
Initial recognition uses the $96,333 issue price under the stated assumptions. Cash increases by that amount and the bond liability begins at the same carrying amount—not at the $100,000 face amount due at maturity.
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| Account | Debit | Credit |
|---|---|---|
| Cash | 96,333 | |
| Bonds Payable | 96,333 |
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| Year | Opening carrying amount | Interest expense | Cash interest | Discount amortized | Closing carrying amount |
|---|---|---|---|---|---|
| 2026 | $96,333 | $5,780 | $4,000 | $1,780 | $98,113 |
| 2027 | $98,113 | $5,887 | $4,000 | $1,887 | $100,000 |
For 2026, the $5,780 effective-interest expense exceeds the $4,000 cash coupon by $1,780. That difference increases Bonds Payable from its discounted carrying amount toward the $100,000 maturity amount.
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| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 5,780 | |
| Bonds Payable | 1,780 | |
| Cash | 4,000 |
Financial-statement effect
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| Statement | Account | Effect |
|---|---|---|
| Income statement | Interest Expense | Increases by $5,780 |
| Balance sheet | Bonds Payable | Carrying amount increases to $98,113 |
| Cash flow statement | Cash interest | Cash decreases by $4,000; classification follows the applicable framework |
- Income statement
- AccountInterest Expense
- EffectIncreases by $5,780
- Balance sheet
- AccountBonds Payable
- EffectCarrying amount increases to $98,113
- Cash flow statement
- AccountCash interest
- EffectCash decreases by $4,000; classification follows the applicable framework
After the second coupon and its $1,887 discount amortization, Bonds Payable reaches $100,000. Repaying that principal removes the liability; it creates no additional interest expense.
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| Account | Debit | Credit |
|---|---|---|
| Bonds Payable | 100,000 | |
| Cash | 100,000 |
Common errors
- Using the coupon rate to calculate expense when the effective yield differs.
- Amortizing a discount in the wrong direction.
- Calling face amount, proceeds, and carrying amount interchangeable.
- Applying this schedule to a liability with different classification or transaction-cost facts.