To understand why a debt instrument might be sold at a discount to par, suppose a firm issues a bond with a face value of $100 and a 5% coupon. If the 5% coupon is low, relative to a “market” rate for comparable debt instruments, investors will require a discount on their purchase of the bond in addition to the 5% coupon. They might pay just $90, rather than $100, for the 5% bond. Taking into effect this discount, the yield to maturity on the bond is higher than the stated 5% coupon and sufficient to attract investor participation.
Book value = Face value – Original issue discount
Zero coupon bonds and debt instruments that pay no stated interest until maturity are also examples of securities with OID.
Accounting for OID
The firm records the bond on its balance sheet at the discounted value upon issuance. Over the life of the bond, the OID amortizes and the book value of the bond accretes to its face value, as seen in the chart to the right.
Interest on the bond, as computed for accounting purposes, captures the total effective interest equal to the stated interest (5% in our example above) plus amortization of the discount. Actual cash interest paid is just the stated interest. The following journal entries demonstrate the appropriate accounting:
Accounting for cash interest
dr. Interest expense – cash interest (SE ↓)
cr. Cash (A ↓)
Accounting for amortization of OID
dr. Interest expense – amortization of OID (SE ↓)
cr. Bond (L ↑)
If the bond is repaid early, before the OID has fully amortized, the issuing firm recognizes a loss because a liability recorded on the balance sheet at a discount (the bond) suddenly becomes payable in full.
Accounting for loss on repayment
dr. Bond (L ↓)
dr. Loss on repayment (SE ↓)
cr. Cash (A ↓)
A Comprehensive Example
These concepts are implemented in the spreadsheet below, with key takeaways highlighted in yellow. On the OID 1 tab, we explore how to model interest on a bond issued at a discount, as well as amortization of that discount. On the OID 2 tab, we add a twist—the debt is repaid before the original issue discount has fully amortized. Note that the repayment framework modeled here is flexible enough to accommodate partial repayment over several periods, in addition to full repayment in a single period.