Amortizing Bond Discount Using the Effective Interest Rate Method

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. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan. The table starts with the book value of the bond which is the face value (250,000) plus the premium on bonds payable (9,075), which equals the amount of cash received from the bond issue (259,075).

The entries for 2022, including the entry to record the bond issuance, are shown next. A business normally issues bonds when they require a source of long-term cash funding. When organizations issue bonds, investors hardly ever pay the face value of the bonds issued, in the case where the coupon rate (i.e. stated interest rate) on the bonds is less than the market interest rate. By paying an amount lesser than the face value of the bond, investors earn a greater return on the reduced investment. In this scenario, the issuing party normally issues the bonds at a discounted rate.

The second way to amortize the discount is with the effective interest method. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period. 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.

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Likewise, the carrying value of the bonds payable equals the balance of bonds payable less the balance of the unamortized bond discount. It is not strange for a company to issue the bond at a discount, in which the selling price of the bond is lower than its face value. Likewise, the company will make the journal entry to account for the bond discount by debiting the amount of the difference between the face value of a bond and its selling price in the unamortized bond discount account. Likewise, the bond discount in this journal entry is the difference between the cash we receive and the face value of the bond we issue. And the normal balance of the bond discount is on the debit side as it is a contra account to the bonds payable.

  • In effect, because the bonds were issued at a premium and the business received more cash than the par value of the bonds, the cost (interest) to the business is reduced each period by the amount of the premium amortized.
  • When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization.
  • If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate.
  • This method is more complex than straight line bond amortization, but also provides a more accurate representation because it considers present value.
  • When the first payment is made, part of it is interest and part is principal.
  • He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

If the book value of the investment declines, then the interest earned will decline also. The effective interest method is used when evaluating the interest generated by a bond because it considers the impact of the bond purchase price rather than accounting only for par value. The net result of this impact difference between bookkeeping and accounting examples is that the total recognized amount of interest expense across the lifespan of the bond tends to be greater than the amount of interest that is actually paid to the investors. The amount subsequently recognized then equates to the market interest rate on the date when the bonds were actually sold.

This increase in value over time is referred to as an accretion of discount. For example, a three-year bond with a face value of $1,000 is issued at $975. Between issuance and maturity, the value of the bond will increase until it reaches its full par value of $1,000, which is the amount that will be paid to the bondholder at maturity. In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank.

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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. In the case where the bond issue took place right before the year-end, the bonds payable account, as well as the bonds payable account would be netted together.

Journal entry for amortization of bond discount

Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. There was no premium or discount to amortize, so there is no application of the effective-interest method in this example. The bonds have a term of five years, so that is the period over which ABC must amortize the discount.

Benefits of Amortized Bonds

The remaining amortization is distributed at maturity, and the discount vouchers increase at maturity only. Notice that under both methods of amortization, the book value at the time the bonds were issued ($104,100) moves toward the bond’s maturity value of $100,000. The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond. When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond.

When a bond is issued at a value above or below its par value, a premium or discount is created. In order to account for the bond properly, this premium or discount needs to be amortized over the lifetime of the bond. 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.

Recordkeeping for Discount Amortizations

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. At the end of year one, you have made 12 payments, most of the payments have been towards interest, and only $3,406 of the principal is paid off, leaving a loan balance of $396,593. The next year, the monthly payment amount remains the same, but the principal paid grows to $6,075. Now fast forward to year 29 when $24,566 (almost all of the $25,767.48 annual payments) will go towards principal.

Amortization of Bond Discount is mainly used to show the actual value of a particular investment, primarily when there is a difference between the coupon rate of the bond and the existing market rate. However, it will also carry an additional expense for the bond discount—in this case, $175 per year. 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.


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