Bond Discount Amortization Journal Entries & Example

When they are issued at anything other than their par value a premium or discount on bonds payable account is created in the bookkeeping records of the business. The bond premium account in this journal entry is an additional amount to the bonds payable on the balance sheet. Likewise, its normal balance is on the credit side which is the same as the normal balance of the bonds payable account. And the amortization can be done through the straight-line method if the amount of bond discount or bond premium is immaterial. On the other hand, if the discount or premium amount is material or significant to financial statements, we need to amortize it through the effective interest rate method.

  • An amortized bond is a bond with the principal amount – otherwise known as face value –regularly paid down over the life of the bond.
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  • Since the effective interest rate of the market is lower than the coupon rate offered by the bank, Lopez Co. does not receive the full amount equivalent to the face value of the bond.
  • As before, the final bond accounting journal would be to repay the face value of the bond with cash.

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. Regardless of the purchase price of the bond, however, all bonds mature at par value. The par value is the amount of money that a bond investor will be repaid at maturity. As the bond gets closer to maturity, the value of the bond declines until it is at par on the maturity date.

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The decrease in value over time is referred to as the amortization of premium. In amortization, premium bondholders are required to reduce the cost base of their possessions in each tax reporting period. The holders of discount bonds use an increase strategy where the base bonds’ base cost increase towards par because the bond moves toward maturity every year. 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. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.

  • For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market.
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  • Although both the par value and coupon rate are fixed at issuance, the bond pays a higher rate of interest from the investor’s perspective.
  • The effective interest method of amortization causes the bond’s book value to increase from $95,000 January 1, 2017, to $100,000 prior to the bond’s maturity.

This ensures a consistent payoff amount across the life of the bond, without any balloon payment or lump sum payoff at the end. At the end of the 3rd year, the $15,000 bond discount will be become zero ($15,000 – $5,000 – $5,000 – $5,000) and the carrying value of the bonds payable will equal $500,000 ($500,000 – $0). Hence, the carrying value of the bonds payable equals the bonds payable plus bond premium. If the bond matures after 30 years, for example, then the bond’s face value plus the interest due is paid off in monthly installments. This procedure ensures that after the discount or premium is fully amortized, the investment account will reflect the bond’s maturity value.

Amortization of bond premium using effective interest rate method

In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price. There are a couple of ways to approach bond amortization, including straight line and effective interest methods. 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. Under the matching principle of accounting, the bond discount should be amortized over the life of the bond; hence, the term “unamortized bond discount” is used here.

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Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (14,880) to the interest expense account. The effective interest method involves preparing a bond amortization schedule to calculate the interest expense based on the market rate at the time the bond was issued and the bonds book value. This interest expense is then compared to the actual interest payment based on the face value of the bond and the bond rate, and grant writing for dummies the difference gives the amount to be amortized to the interest expense account. In accounting, we may issue a bond at a discount or at a premium which results in the carrying value of the bonds payable recorded on the balance sheet being lower or higher than the face value of the bond. Of course, we can use some tools to calculate the effective interest rate such as the excel spreadsheet where we can calculate the effective interest rate using the IRR() formula.

Amortization of discount on bonds payable

The following table summarizes the effect of the change in the market interest rate on an existing $100,000 bond with a stated interest rate of 9% and maturing in 5 years. This method is more complex than straight line bond amortization, but also provides a more accurate representation because it considers present value. Accretion can also be accounted for using a constant yield, whereby the increase is closest to maturity. The constant yield method is the method required by the Internal Revenue Service (IRS) for calculating the adjusted cost basis from the purchase amount to the expected redemption amount. This method spreads out the gain over the remaining life of the bond, instead of recognizing the gain in the year of the bond’s redemption.

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.

Hence, we need to make the amortization of the bond discount in order to have the carrying value of bonds payable equaling the face value of the bond at the end of the bond maturity. By the time the loan is preparing to reach maturity (around year 28 or 29), the majority of the yearly payments will go toward reducing the remaining principal. By the 29th year, roughly $11,000 of the annual payments of $12,883 are now going toward the principal rather than merely paying interest on the loan.

Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense. For loans such as a home mortgage, the effective interest rate is also known as the annual percentage rate. The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan. For example, effective interest rates are an important component of the effective interest method.

Effective-interest method requires a financial calculator or spreadsheet software to derive. 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.

According to the Internal Revenue Service, premium amortization in the fiscal accounts does not result in the capital loss for the client. With the discount vouchers, the cost base of a US savings bond is raised and is also a taxable capital gain. Investors who purchase only the bonds sold at par are those who avoid the inconvenience of reporting the changes for each bond. Other tax effects The price of bonuses varies each day, and the amortization is based on the reality the bonds must be exchanged in at maturity. The bond traders are required to use the new amortized cost in case a bond in negotiated before its maturity.


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