Amortizing Bond Discount Using the Effective Interest Rate Method

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The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life. By reducing the bond premium to $0, the bond’s book value will be decreasing from $104,100 on January 1, 2022 to $100,000 when the bonds mature on December 31, 2026. Reducing the bond premium in a logical and systematic manner is referred to as amortization.

Bond Pricing

As IRS Publication 550 states, for bonds issued after Sept. 27, 1985, taxpayers must amortize bond premium using the constant-yield method, which differs from the straight-line method. For older bonds issued before Sept. 27, 1985, the straight-line method is still an option. Once the bond https://adprun.net/i-m-confused-how-do-you-use-opening-balance-equity/ premium is calculated, you need to decide how the bond premium shall be amortized. Based on your chosen method, you can amortize the bond premium in the books of accounts. Interest expense is calculated as the effective-interest rate times the bond’s carrying value for each period.

• Therefore, the interest rate is constant over the term of the bond, but the actual interest expense changes as the carrying value of the bond changes.
• It has to be done when bonds are issued at a premium above their face value.
• The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period.
• The total interest expense for each payment period is then multiplied by the number of periods, and the resulting product is subtracted from the cash payment to arrive at a new value.
• The table starts with the book value of the bond which is the face value (250,000) less the discount on bonds payable (8,663), which equals the amount of cash received from the bond issue (241,337).

The table is commonly used by the issuers of bonds to assist them in accounting for these instruments over time. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is reduced to 250,000, and the premium on bonds payable (9,075) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 250,000, and the discount on bonds payable (8,663) has been amortized to interest expense. As before, the final bond accounting journal would be to repay the face value of the bond with cash. In order to calculate the premium amortization, you must determine the yield to maturity (YTM) of a bond.

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Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000. The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period.

The effective interest method of amortization is a process used to allocate the discount or premium on bonds, or other long-term debt, evenly over the life of the instrument. If a corporation issues only annual financial statements and its accounting year ends on December 31, the amortization of the bond premium Classified Balance Sheet Financial Accounting can be recorded once each year. In the case of the 9% $100,000 bond issued for $104,100 and maturing in 5 years, the annual straight-line amortization of the bond premium will be $820 ($4,100 divided by 5 years). When we issue a bond at a premium, we are selling the bond for more than it is worth.

Amortizing Bond Premium With the Constant Yield Method

Par value, in turn, is simply another term for the bond’s face value, or the stated value of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year. For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount. For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond.

• The effective interest method is an accounting practice used to discount a bond.
• As IRS Publication 550 states, for bonds issued after Sept. 27, 1985, taxpayers must amortize bond premium using the constant-yield method, which differs from the straight-line method.
• Assume that a corporation issues bonds payable having a maturity value of $1,000,000 and receives a premium of $60,000.
• On January 1, 2022 the book value of this bond is $104,100 ($100,000 credit balance in Bonds Payable + $4,100 credit balance in Premium on Bonds Payable).
• The entries for 2022, including the entry to record the bond issuance, are shown next.