Thomson Reuters can help you better serve clients by delivering expert guidance on amortization and other cost recovery issues for more tax-efficient decisions. In this article, we’ll explore what bond amortization means, how to calculate it, and more. Straight-line amortization has the advantage of being a simpler and more straightforward method. The straight-line method can be better suited for smaller companies with leaner accounting departments, allowing accountants to calculate amortization more quickly. However, accounting software packages and free online amortization calculators can eliminate this advantage, as they can calculate amortization using any method instantly. This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.
We focus on financial statement reporting and do not discuss how that differs from income tax reporting. Therefore, you should always consult with accounting and tax professionals for assistance with your specific circumstances. When bond interest rates are discussed, the term basis point is often used.
For discount bonds, in consecutive years, straight line method of bond discount we will adjust the historical cost up until we reach the bond’s par value and for premium bonds, we will adjust the historical cost down until we reach the par value. However, the straight-line method assumes that in each period throughout the bond’s life, the value of the adjustment is the same. According to the effective interest rate method, the adjustment reflects the reality better.
To illustrate the discount on bonds payable, let’s assume that in early December 2023 a corporation prepares a 9% $100,000 bond dated January 1, 2024. The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2028. Once a bond is issued the issuing corporation must pay to the bondholders the bond’s stated interest for the life of the bond. Let’s assume that on January 1, 2024 a corporation issues a 9% $100,000 bond at its face amount. The bond is dated January 1, 2024 and requires interest payments on each June 30 and December 31 until the bond matures at the end of 5 years.
Differences in Premium/Discount Amortization Methods
Let’s illustrate this scenario with a corporation preparing to issue a 9% $100,000 bond dated January 1, 2024. The bond will mature in 5 years and requires interest payments on June 30 and December 31 of each year until December 31, 2028. The bond is issued on February 1 at its par value plus accrued interest. While the issuing corporation is incurring interest expense of $24.66 per day on the 9% $100,000 bond, the bondholders will be earning interest revenue of $24.66 per day. With bondholders buying and selling their bond investments on any given day, there needs to be a mechanism to compensate each bondholder for the interest earned during the days a bond was held. The accepted technique is for the buyer of a bond to pay the seller of the bond the amount of interest that has accrued as of the date of the sale.
Calculating the Present Value of a 9% Bond in an 8% Market
Using the straight-line amortization method, accountants transfer an equal amount from the bond discount or premium account over to the interest expense account each payment period. For bond discounts, accountants add onto the interest expense balance each month, to account for the additional expense of selling a bond at a discount and repaying it at face value. As the bond discount is amortized, it increases the interest expense recorded on the income statement. In our example, the annual interest expense would be the sum of the coupon payment ($30) and the amortization of bond discount ($10), resulting in a total interest expense of $40. This reflects the higher effective interest rate required by investors due to the bond’s lower coupon rate. In this method, the premium or discount is amortized based on the bond’s effective interest rate over its full maturity period.
Summary of the Effect of Market Interest Rates on a Bond’s Issue Price
For example, if a market interest rate increases from 6.25% to 6.50%, the rate is said to have increased by 25 basis points. Bonds allow corporations to use financial leverage or to trade on equity. The reason is that a corporation issuing bonds can control larger amounts of assets without increasing its common stock. The bond’s total present value of $96,149 is approximately the bond’s market value and issue price. As we had seen, the market value of an existing bond will move in the opposite direction of the change in market interest rates.
Double Entry Bookkeeping
Such bonds were known as bearer bonds and the bonds had coupons attached that the bearer would “clip” and deposit at the bearer’s bank. Let’s use the following formula to compute the present value of the maturity amount only of the bond described above. The maturity amount, which occurs at the end of the 10th six-month period, is represented by “FV” . The journal entries for the remaining years will be similar if all of the bonds remain outstanding. The journal entries for the years 2025 through 2028 will be similar if all of the bonds remain outstanding. Market interest rates are likely to increase when bond investors believe that inflation will occur.
The discount is the difference between the amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the terms discount on bonds payable, bond discount, or discount. The straight-line method for unamortized bond discount offers numerous benefits to both bond issuers and bondholders. Its simplicity, consistency, accurate representation, and enhanced decision-making capabilities make it an attractive choice for those looking for a simplified approach to bond accounting.
- The amount subsequently recognized then equates to the market interest rate on the date when the bonds were actually sold.
- The straight-line method allocates a fixed portion of the bond discount or premium each interest period to adjust the interest payment to interest expense.
- Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.
Convertible bonds allow the bondholder to exchange the bond for a specified number of shares of common stock. Bonds that have specific assets pledged as collateral are secured bonds. An example of a secured bond would be a mortgage bond that has a lien on real estate. Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.
This means the amortization schedule accounts for the time value of money, and the interest expense recognized each period reflects the bond’s current carrying value. Since this method uses the bond’s market yield at issuance and assumes the bond will not be called, the amortization is evenly spread but changes slightly based on the bond’s remaining balance. This method is generally more accurate and reflects the true cost or benefit to the investor or issuer across the bond’s life. This bond amortization calculator can be used for any bond up to a maximum term of 200 interest payment periods. To illustrate the application of the straight-line method, let’s consider an example.
When a corporation prepares to issue/sell a bond to investors, the corporation might anticipate that the appropriate interest rate will be 9%. If the investors are willing to accept the 9% interest rate, the bond will sell for its face value. If however, the market interest rate is less than 9% when the bond is issued, the corporation will receive more than the face amount of the bond. The amount received for the bond (excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on bonds payable, bond premium, or premium. 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 120,000, and the premium on bonds payable (2,204) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash.
- Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing.
- Much like the bank receiving regular payments over the life of the mortgage loan, the bond holder receives regular payments of both principal and interest until the bond reaches maturity.
- The effective-interest method to amortize the discount on bonds payable is often preferred by auditors because of the clarity the method provides.
- 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 120,000, and the premium on bonds payable (2,204) has been amortized to interest expense.
- However, the straight-line method assumes that in each period throughout the bond’s life, the value of the adjustment is the same.
An existing bond’s market value will increase when the market interest rates decrease. An existing bond becomes more valuable because its fixed interest payments are larger than the interest payments currently demanded by the market. An existing bond’s market value will decrease when the market interest rates increase.The reason is that an existing bond’s fixed interest payments are smaller than the interest payments now demanded by the market.
When it comes to bonds, understanding the concept of bond discount and its accounting treatment is crucial for investors and financial professionals alike. A bond discount occurs when the market interest rate is higher than the coupon rate offered by the bond, resulting in the bond being sold at a price lower than its face value. This discount represents the additional yield investors require for purchasing a bond with a lower coupon rate. In this section, we will delve into the intricacies of bond discount and explore its accounting treatment. Understanding unamortized bond discount and the Straight-Line Method is crucial for anyone involved in bond investments or financial management. This accounting method simplifies the process of spreading the discount over a bond’s life, ensuring that both issuers and investors can accurately track and report the financial impact of discounted bonds.