Balance Sheet treatment of Discount Bonds

CFA Level I FRA
#1

Slightly confused over the balance sheet treatment of the amortization of a discount/premium for bonds. Don’t know if I’m missing something or overthinking it.

So lets take a discount bond for example. So the book value of the liability (on the balance sheet) for a discount bond will increase throughout the life of the bond (by the amount of amortization of the discount) and ultimately end up at face value at maturity right? (ie the book value of the liability will be recorded at PV on balance sheet at time of issuance and inch up towards the face value and thus converge at time of maturity)

So if the liability side of the balance sheet increases (converges to the par value) as time goes by during the life of the bond, what is the corresponding increase on the asset side? Doesn’t something need to “balance out” this increasing liability? will it be increasing cash? decreasing equity?

When you issue a bond lets say you get cash (assets) but also record an increase in long term debt/notes payables (liability). so I see that the balance sheet is balanced here, in the beginning. but what about throughout the life of the bond as the carrying value of liability increases (towards the par value)?

#2

Hi there,

I think I understand your question.

During a bond’s life, the liability of a discount bond will indeed increase over time.This will be balanced by a increase in the interest expense, which will make Equity (Retained earnings through Net Income) decrease, and balance the accounting equation.

Note that the interest expense is a function of the beginning period liability (which both increase over time in the case of a discount bond).

Also, the interest expense is composed by the coupon payment (fixed) and the discount amortization.

Hope this helps.

#3

Anasrouetbi makes perfect sense! thnx! it is all clear now. :smiley:

I’m assuming it will be the same concept but reversed (ie increase in Equity along with the decrease in liability of premium bond) for premium bonds (and the subsequent amortization of premium)?

#4

Yep it is the same logic.

Cheers !