A bond is a long-term liability often issued by governments and nonprofit organizations. Bonds can be issued in detachable units, which allows for a wider potential pool of investors. For example, a $10,000,000 bond can be broken up across investors in increments of $1,000, and thus 10,000 investors could be involved, while a $10,000,000 note payable may require one single lender to provide the full $10,000,000. Bonds are often used to finance massive projects, such as construction of schools and government enterprises. Notes payable, on the other hand, are usually owned by a single entity or small group of entities. Bonds can also be used for continuous financing of entities not allowed to be owned in stock, such as public utilities.
Bonds payable also carry formal terms. For example, many bonds are stipulated to pay interest quarterly or semiannually at the stated rate of interest on the bond regardless of the market rate of interest. The contract rate, which is the rate of interest to be paid at fixed intervals, is also known as coupon rate or stated rate. The face amount is the actual amount shown on a bond or note that reflects the principal amount borrowed. Selling a bond at a higher market price than its face amount is known as selling at a premium. Selling a bond with a stated rate that is lower than market rate, resulting in a bond sale price below face value, occurs when bonds sell at a discount. When issued, bond prices are usually expressed in terms of a 100 scale, where 100 represents 100% of the face amount of the bonds. Bonds sold at a discount, or less than 100, such as 97, for example, would be selling at 97% of the face amount. Bonds sold at a premium, or more than 100, such as 105, for example, would be selling at 105% of the face amount. The way this might be expressed for a bond discount (where the market rate of interest exceeds the stated rate) is as follows:
The town of Blue sold Series A bonds with a face amount of $50,000,000 and a stated rate of interest of 10% at 97.
These bonds would sell at 97% of face value, or $48,500,000. The difference would be known as the discount on bonds payable.
Amortization is spreading or allocating a cost or payment over a period of time. Since discounts and premiums can be material, accounting conventions suggest that it is best to amortize them, or spread these premiums and discounts over the life of the bond rather than recognizing a large adjustment in the current period. While accrual accounting suggests interest expense should accrue at a market rate, the effect of amortization is to recognize the difference in market interest rate and stated interest rate.