What it means
Suppose a company issues a bond with a face value of $1,000,000 but receives only $950,000 because the interest rate on the bond is lower than the rate investors demand. The $50,000 difference is the discount.
It is a real cost of borrowing, but it is not paid in cash until the bond matures, so accounting spreads it over the years the money is borrowed. Each period, a slice of the discount is moved from the balance sheet into interest expense.
That process is amortisation (spreading a cost over time), and the amount not yet moved is the unamortised discount. The balance falls every period until it reaches zero on the maturity date.
On the balance sheet, the unamortised discount is shown as a reduction from the bond's face value, so the liability appears at its carrying value (face value less the unamortised discount). Under current international and US standards, the discount is presented as a deduction from the debt and not as a separate asset.
The carrying value rises towards face value as time passes. Two methods are common.
The straight-line method charges an equal amount each period and is simple, while the effective interest method charges a constant percentage of the carrying value and is the preferred approach for most reporting. The effective interest method produces a rising expense because the carrying value grows each period.
For a manager, the figure is worth watching because it means reported interest expense is higher than the cash coupons paid. It also explains why the debt on the balance sheet is lower than the amount the company will eventually repay.
Lenders and analysts look at the discount when they compare companies, because two issuers with the same coupon can report different interest costs. The unamortised balance is also a useful reminder that part of the borrowing cost is still to come through the income statement.
In practice
Real-world examples.
Example
A manufacturer issues five-year notes with a $2,000,000 face value at a price of $1,900,000. The $100,000 discount is charged at $20,000 a year, so after two years the unamortised discount is $60,000.
Example
A retailer issues bonds that pay a 4% coupon when the market asks for 5%. Investors pay less than face value, and the retailer records the gap as a discount that increases its interest expense above the cash coupons it pays. The cash outlay each year stays the same, but the reported cost is higher.
Example
A property developer's finance team prepares year-end accounts for a bond with 6 years left and an unamortised discount of $24,000. The balance sheet shows the bond at its face value less $24,000, and the next year's interest expense includes the next slice. The auditor agrees the balance to the amortisation schedule.
Formula
Calculation
Unamortised discount = Face value - Issue price - Discount amortised to date
Carrying value = Face value - Unamortised discount
A company issues $1,000,000 of bonds for $950,000, so the discount is $50,000, spread evenly over 10 years using the straight-line method. Each year, 50,000 / 10 = $5,000 is charged. After 4 years, amortised discount is 4 x 5,000 = $20,000, so the unamortised discount is 50,000 - 20,000 = $30,000. The carrying value is 1,000,000 - 30,000 = $970,000.Case study
Seen in the real world.
Redwood Components is an illustrative, fictional manufacturer that issued $5,000,000 of eight-year bonds at $4,800,000 to fund a new plant. The $200,000 discount was recorded on the day of issue, and the controller set up a schedule using the straight-line method for simplicity.
At the end of year three the schedule showed $75,000 of amortised discount and $125,000 still unamortised. A new analyst compared cash interest paid with reported interest expense and asked why the two figures differed by $25,000 each year.
The illustrative answer was that the extra $25,000 is the yearly discount charge, a non-cash cost that brings the bond's carrying value up to $5,000,000 by maturity. After that explanation the board treated the reported interest cost as the true cost of the borrowing. The analyst also built a simple chart of the carrying value rising from $4,800,000 towards $5,000,000, which made the idea easy to explain to non-finance directors.
Watch out
Common mistakes.
- Recording the discount as an immediate expense on the issue date instead of spreading it across the life of the bond.
- Showing the unamortised discount as an asset, when it reduces the liability's carrying value.
- Forgetting that interest expense is higher than the cash coupons because of the non-cash discount charge.
Questions
People also ask.
Why does the balance shrink over time?
Each period a portion is charged to interest expense, so by maturity the whole discount has been charged and the carrying value equals face value.
What is the difference between straight-line and effective interest amortisation?
Straight-line charges equal amounts each period, while the effective interest method charges a fixed rate on the opening carrying value, which is more precise.
Does the discount affect cash flow?
Not until maturity, because the cash cost is the difference between what was received and what is repaid, but the tax deduction may follow the accounting charge.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%