An original issue discount is the difference between the face amount of a bond and the price at which it is originally sold to an investor by the issuer. When the bond is eventually redeemed on its maturity date, this discount is paid to the investor, which represents a profit for the investor. For accounting purposes, the discount is treated as interest expense by the issuer, and as interest income by the investor, and is recognized as such in their accounting records.
For example, an investor purchases a bond for $900 from the issuer. The face value of the bond is $1,000. The issuer is willing to accept a lower price, because the stated interest rate on the bond is currently lower than the market interest rate, and accepting a lower price raises the effective interest rate for the buyer. When the issuer redeems the bond, it pays the investor the full $1,000 face value of the bond.
The amount of an original issue discount can be particularly large when the issuer sells zero-interest bonds. In this case, the amount of the discount represents the sole form of income for the investor, who will therefore bid a substantially lower amount than the face value before agreeing to purchase the bonds.
The amount of an original issue discount is reported by the investor as part of taxable income as it accrues over the remaining life of the underlying bond, irrespective of the receipt of any payments from the issuer during that time. In addition, the investor may pay taxes on the actual interest income received, and on any realized appreciation in the market price of the underlying bond.