This method is more complex than straight line bond amortization, but also provides a more accurate representation because it considers present value. Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest. Assume that the final payment will be $2,774.99 in order to eliminate the potential rounding error of $1.06.
- Exchange of taxes means that there are commercial ties with the losses of the same type of bonds to ensure the recognition of tax loss for purposes of income tax.
- However, for ease of illustration, the straight-line method is used in this article.
- Treasury bond, although the same principles apply to corporate bond trades.
- The difference between both, the actual cash received as well the face value is debited as a discount offered on bonds payable.
- Amortization is a process carried out to reduce the cost base of a bond for each period to reflect the economic reality of the bonds approaching maturity.
- As is the case for something like depreciation, straight line bond amortization involves the same amount of interest expense each year over the life of the bond.
However, for ease of illustration, the straight-line method is used in this article. Amortization is an accounting method that gradually and systematically reduces the cost balance sheet items items of balance sheet with explanation value of a limited-life, intangible asset. The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond.
Example of Amortization of Bond Discount – Straight Line Method
Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond. If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%. While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate. As mentioned, the unamortized bond discount is a contra account to the bonds payable on the balance sheet.
- This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion.
- The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond.
- To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022.
- The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check.
On a period-by-period basis, accountants regard the effective interest method as far more accurate for calculating the impact of an investment on a company’s bottom line. To obtain this increased accuracy, however, the interest rate must be recalculated every month of the accounting period; these extra calculations are a disadvantage of the effective interest rate. If an investor uses the simpler straight-line method to calculate interest, then the amount charged off each month does not vary; it is the same amount each month. If the bond in the above example sells for $800, then the $60 interest payments it generates each year represent a higher percentage of the purchase price than the 6% coupon rate would indicate.
Discounted Bond Example
Consequently, as a bond’s book value increases, the amount of interest expense increases. 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 increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. 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.
What is the Amortization of Discount on Bonds Payable?
This ensures a consistent payoff amount across the life of the bond, without any balloon payment or lump sum payoff at the end. In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. She will repay the loan with five equal payments at the end of the year for the next five years.
In accounting, the effective interest method examines the relationship between an asset’s book value and related interest. In lending, the effective annual interest rate might refer to an interest calculation wherein compounding occurs more than once a year. In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price. 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 principal paid off over the life of an amortized loan or bond is divvied up according to an amortization schedule, typically through calculating equal payments all along the way. This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion. As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger. The calculations for an amortizing loan are similar to that of an annuity using the time value of money, and can be carried out quickly using an amortization calculator. Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.
Straight-Line Amortization of Bond Discount on Monthly Financial Statements
If the bond sells at a discount, the business would amortize the discount amount over the life of the bond at the effective market rate. And if it sells at a premium, the business would subtract the premium amount over the life of the bond at the effective market rate. In both cases, the closer to the maturity date, the closer the interest expense gets to the par value of the bond. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing.
In the calculation of the cash flow, the non-monetary interest expenses are added in the amortization of the discounted bond to the net income. When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account.
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. Lopez Co. has issued a bond equivalent to $10,000,000, for a time to maturity of 5 years. 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. After all, investors are unlikely to pay for the bonds at the face value if they can invest in other securities with similar risks but providing a better rate of return.
Now fast forward to year 29 when $24,566 (almost all of the $25,767.48 annual payments) will go towards principal. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly. 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.
What Is the Effective Interest Method of Amortization?
Likewise, with the amortization, the balance of the unamortized bond discount will be reduced throughout the life of the bond until it becomes zero at the end of bond maturity. There are a couple of ways to approach bond amortization, including straight line and effective interest methods. Both are recognized under Generally Accepted Accounting Principles (GAAP). How a business chooses to account for bond amortization depends on the nature of the bond, the company’s financial strategy and the amounts in question.