On January 1, 2012, Wormer Company issues $200,000 of 6% bonds. Interest of $6,000 is payable semi-annually on June 30 and Dec 31. The bonds mature in 5 years and sell for $191,684. On June 30, 2012, the company recognizes interest expense of $6,709. As a result of recognizing this transaction, the bond carrying value will:
Increase by $709.

Interest expense is usually $6000.
$709 is the leftover amount, so it increases the liability and is reflected as a reduction in the discount (a contra-liability account).
Essentially, it is a discount on bonds payable.

Carrying value will increase by $709.

Explanation:

Corporations issue bonds at face value or a value close to face value. When bonds are issued at a price lower than the face value, in this case, then these bonds are known as discount bonds. When these bonds are issued, companies record a liability for the actual amount received. It is obvious that at the maturity, these issued discounted bonds will be redeemed at its face value. Thus, the amount of liability recorded at the start of bond term is gradually increased over the term of contract to make the balance of liability equal to face value.

Let's understand this though Journal Entries.

- When bond are issued on January 1, 2012:

Cash (Dr.)                                          $191,684

Discount on Bonds Payable                  8,316

                   Bonds Payable                                         $200,000      

The Discount on Bonds Payable is a contra-liability account. It has a debit balance and hence reduces the carrying value of Bonds Payable. The net carrying value of the bonds payable on January 1, 2012 will be $191,684 (200,000 - 8,316).

The matching principal requires us to recognize this additional payment of $8,316 over the life of bond contract in-spite of the face that it is paid at the end of maturity.

- When the first semi-annual interest payment is made:

Interest Expense (Dr.)                                $6,709            

                         Cash                                                         $6,000

                         Discount on Bonds Payable                         709

where

Interest Expense calculation is as follows:

Interest Expense Semi-Annual (200,000 * .06 * 1/2)                           $6,000

Add: Discount on Bonds Payable                                                               709

Since the Contra-liability account has a debit balance, a credit to it will decrease it, and as a result the carrying value of bonds payable will increase. This treatment will carry on over the term of the contract and at the maturity the carrying value will be equal to face value.

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