El carrito está vacío In this article, we’ll explore what bond amortization means, how to calculate it, and more. Alternatively, the bond’s carrying value on 1 July 2020 is equal to the unamortized discount of $6,516. Let’s now consider how to use the effective interest method for both the discount and premium cases. In the premium example, the same conceptual problem occurs, except that the percentage rate continuously increases as the carrying value of the bond decreases from $107,722 to $100,000. An interest-bearing asset also has a higher effective interest rate as more compounding occurs.
In this journal entry, the carrying value of the bonds payable on the balance sheet is $485,000 as the $15,000 bond discount is a contra account to the $500,000 bonds payable. Likewise, we can make the journal entry for the amortization of bond discount by debiting the interest expense account and crediting the bond discount account. The discount on bonds payable account has a debit balance of 8,663 which needs to be amortized to the interest expense account over the lifetime of the bond. Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.
- On the other hand, the effective interest rate method will require us to determine the discounted future cash flow of the bond before calculating the rate to apply to the carrying value of bonds payable.
- Since the maturity is for a duration of 5 years, the same discount is going to be charged across all the years for bond amortization.
- The amount recognized equates to the market rate of interest on the date when the bonds were sold.
- This process repeats itself for each period until no discount or premium remains on the principal balance.
- The company usually issues the bond at a discount when the market rate of interest is higher than the contractual interest rate of the bond.
The effective interest method will allow you to record more interest revenue in early years and less interest revenue in later years. The Investment in Bonds account is debited for four months of discount amortization. The total discount is $240 and is amortized over the remaining 58 months of the bond’s life at the time of issue. In our example, the bond discount of $3,851 results from the corporation receiving only $96,149 from investors, but having to pay the investors $100,000 on the date that the bond matures. The discount of $3,851 is treated as an additional interest expense over the life of the bonds. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization.
The Rationale Behind the Effective Interest Rate
When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. Therefore, the amortization causes interest expense in each accounting period to be higher than the amount of interest paid during each year of the bond’s life. Treating a bond as an amortized asset is an accounting method used by companies that issue bonds. It allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its face value and sold at a premium when the price received is greater than face value.
Although you will owe federal taxes on income from government bonds such as Treasury bills and notes, your earnings are tax-free at the state and local levels. Likewise, at the end of the maturity of the bond, the $12,000 of the bond premium will become zero. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.
- This is not the case; however, you must follow certain guidelines when it comes to reporting negative amounts on your balance sheet if you choose to take them into account in determining net income.
- Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable.
- Discounted bonds’ amortization always leads to an effective interest expense that is higher than the payment of the bond interest coupon for each period.
- Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense.
With the effective interest method, as with the straight-line method, the total interest expense is $67,024. Importantly, there is no difference in the total interest expense within the 5-year period of time; there is only a difference in the allocation. For example, under this method, each period’s dollar interest expense is the same. However, as the carrying value of the bond increases or decreases, the actual percentage interest rate correspondingly decreases or increases. When you use the effective interest method, the carrying value of the bonds is always equal to the present value of the future cash outflow at each amortization date.
A Bond’s Par Value
Bond discount arises when the rate of return expected in the market on a bond is higher than the bond’s coupon rate. This causes the bond to sell at a price lower than the face value of the bond and the difference is attributable to bond discount. Similarly, bond premium occurs when the coupon bench bookkeeping review rate is higher than the market expectation of required return. Due to higher coupon rate, there is high demand for the bond and it sells for a price higher than the face value of the bond. The difference between the face value of the bond and the bond price is called bond premium.
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. 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. Discounted bonds’ amortization always leads to an effective interest expense that is higher than the payment of the bond interest coupon for each period.
Government Bonds
The effective interest rate is a more accurate figure of actual interest earned on an investment or the interest paid on a loan. Amortization can be defined as a process that is carried out to reduce the cost base of a given bond for each subsequent period in order to reflect the nearing maturity date of the relevant financial statement. While you won’t pay state and local taxes on government bonds or savings bonds, you will still be on the hook for federal taxes. Municipal bonds are likely your best option to avoid taxes altogether, as they are typically free from federal taxes and exempt from state and local taxes if you live in the area where the “muni” is issued. However, it is not necessary for investors to amortize premiums in the year they buy the bond, because they may begin doing so in any tax year. But it’s important to remember that investors who elect to amortize the premium for one bond must also amortize the premium for all other similar bonds, both for that year and for years going forward.
The difference between the required cash interest payment of $6,000 in Column 3 ($100,000 x 6%) and the effective interest expense of $6,508 is the required discount amortization of $508 in Column 4. In the next interest period, this rate falls to 7.15% because the interest expense for the period remains at $6,702. However, as shown in our article covering bonds issued at a discount, the carrying value of the bonds has increased to $93,678. For example, on February 1, the company ABC issues a $100,000 bond with a five-year period at a discount which it sells for $97,000 only. There can be different tax implications for investing in bonds, depending on the type of fixed-income security you purchase.
Example of Bond Amortization
When we issue a bond at a premium, we are selling the bond for more than it is worth. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable. Just like with a discount, the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual interest payment. Using the straight-line method, bond amortization results in bond discount amortization values that are equal throughout the term of the bond.
The difference between this amount and the cash interest in Column 3 is the premium amortization in Column 4. The bond’s carrying value at the end of the period in Column 6 is reduced by the premium amortization for the period. For each period, the interest expense in Column 2 is the semiannual yield rate at the time of issue, 5%, multiplied by the carrying value of the bonds at the beginning of the period.
Premiums are handled in a similar manner except that the premium decreases interest revenue and is recorded by crediting the Investment in Bonds account. This $417 consists of 4 months’ cash interest plus $17 of the amortized discount. Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense. This equals $4.14 ($240 + 58 months — $4.14) per month, and 4 months’ amortization from 1 March 2020 to 1 July 2020 is $16.56 ($4.14 x 4). Regardless of the method that you apply as an accountant, the discount is amortized by debiting the Investment in Bonds account.
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