Chapter 2 91® Amortizing a Bond Premium Interest Expense Straight Line Method & Effective Interest Method Example

In each of the years 2025 through 2028 there will be 12 monthly entries of $750 each plus the June 30 and December 31 entries for the $4,500 interest payments. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched. Under US GAAP and IFRS, goodwill is never amortized, because it is considered to have an indefinite useful life. The difference of $7,580 between the face value of bond of $100,000 and the proceeds of $92,420 represents the discount on bond. The straight-line and effective-interest methods are two common ways to calculate amortization. Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team.

Journal Entry at Issuance:

As a bond discount arises when coupon rate is lower than the market rate, the bond discount amortization must be added to the interest payment to arrive at market-equivalent interest expense. In the straight-line method of amortization of bond discount or premium, bond discount or premium is charged equally in each period of the bond’s life. Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. Since they promised to pay 5% while similar bonds earn 7%, the company, accepted less cash up front.

Calculating the Present Value of a 9% Bond in an 8% Market

A coupon rate is the yield paid by a fixed income security, which is the annual coupon payments divided by the bond’s face or par value. Bonds are secured when specific company assets are pledged to serve as collateral for the bondholders. If the company fails to make payments according to the bond terms, the owners of secured bonds may require the assets to be sold to generate cash for the payments. The remaining balance of debt issuance expenses that were capitalized and are being amortized against income over the lives of the respective bond issues.

Amortization of the discount or premium

• The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.
• This premium on bonds payable is a contra account to bonds payable and is reported in the equity section of the balance sheet.
• Suppose a company, BizCorp, issues $100,000 worth of 10-year bonds with a stated interest (coupon) rate of 6%.
• It is because the bond is overcompensating the bond-holder in terms of interest payments and the bond must fetch a premium.

The premium is essentially the investor’s upfront payment for the additional interest income they will receive over the life of the bond. If the stated interest rate on a bond is less than the market interest rate, it is not uncommon for an investor to pay less than the face value of the bond. In this instance, the difference between the face value and the amount paid is placed in a contra liability account, and the amount of the reduced payment is amortized over the term of the bond. On the other hand, if the interest rate stated on the face of a bond is greater than the prevailing market rate on the date of issuance, the bond will be sold at a higher price than the face value. The buyer would receive higher interest payments than what is potentially available on the current market. This is called a bond premium, and would also be recognized on the financial statements of the bond issuer.

Amortization of bond discount using straight-line

• Since the corporation issuing a bond is required to pay interest, and since the interest is paid on only two dates per year, the interest on a bond will be accruing daily.
• Recall that this calculation determines the present value of the stream of interest payments only.
• The effective-interest method to amortize the discount on bonds payable is often preferred by auditors because of the clarity the method provides.
• Because the purchase price of bonds can vary so widely, the actual rate of interest paid each year also varies.
• The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond.

The discount will increase bond interest expense when we record the semiannual interest payment. Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 241,337 representing a market rate of 12%. The premium on bonds payable account has a credit balance of 9,075 which needs to be amortized to the interest expense account over the lifetime of the bond. Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 259,075 representing a market rate of 8%. When they are issued at anything other than their par value a premium or discount on bonds payable account is created in the bookkeeping records of the business.

Typically, the calculations are done in such a way that each amortized bond payment is the same amount. An organization with a bond payable will commonly make periodic payments to its bondholders towards the interest owed on the bonds. Payments for the principal amount of a bond can be made at regularly prescribed intervals or the entire principal amount of the bond is paid at the date of maturity. Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.

Bonds are generally thought to be lower risk than stocks, which makes them a popular choice among many investors. And for companies issuing a bond, bond amortization can prove to be considerably beneficial. Over the life of the bond, BizCorp will amortize the premium, which means it will gradually reduce the Premium on Bonds Payable account balance and record it as a reduction in interest expense. Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. Each journal entry must have the dollars of debits equal to the dollars of credits.

IFRS does not permit straight-line amortization and only allows the effective-interest method. The extra $1,000 is considered a premium on the bonds payable and is initially recorded as a credit in the Premium on Bonds Payable account. Second, we establish what area of the financial statements are impacted by issuing the bonds.

Each year, the premium of $800 will be amortized, and the carrying value of the bond will decrease by $800. By the end of the 5-year period, the carrying value of the bond will equal its face value of $100,000. Using the straight-line method, we can amortize the $12,000 bond the amortization of premium on bonds payable premium to be $4,000 per year for each of the three years of bond periods. Calculating Bond Premium amortized can be done by any of the two methods mentioned above, depending on the type of bond. The Straight Line method of amortizationgives the same interest expenses in each period.

Balance Sheet

This can be done with computer software, a financial calculator, or a present value of an ordinary annuity (PVOA) table. Present value calculations are used to determine a bond’s market value and to calculate the true or effective interest rate paid by the corporation and earned by the investor. Present value calculations discount a bond’s fixed cash payments of interest and principal by the market interest rate for the bond. When we issue a bond at a premium, we are selling the bond for more than it is worth.

If investors will be receiving an additional $500 semiannually for 10 semiannual periods, they are willing to pay $4,100 more than the bond’s face amount of $100,000. The $4,100 more than the bond’s face amount is referred to as Premium on Bonds Payable, Bond Premium, Unamortized Bond Premium, or Premium. The present value (and the market value) of this bond depends on the market interest rate at the time of the calculation.

The accounting treatment for Interest paid and bond premium amortized will remain the same, irrespective of the method used for amortization. The effective interest method is a more accurate method of amortization, but also calls for a more complicated calculation, since it changes in each accounting period. This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results. For investors, there can be tax implications for the amortization of bond premiums or discounts. Using an amortization schedule, the bond’s principal is divided up and paid off incrementally, usually in monthly installments. For instance, if the bond matures after 30 years, then the bond’s face value, plus interest, is paid off in monthly payments.