Amortization of premium on bonds payable

With the straight-line method, you are debiting more interest revenue each year until there is no remaining bond discount or premium. The effective interest method will allow you to record more interest revenue in early years and less interest revenue https://accounting-services.net/should-i-recognize-a-bond-premium-amortization-on/ in later years. This procedure ensures that after the discount or premium is fully amortized, the investment account will reflect the bond’s maturity value. Amortizable Bond Premium refers to the cost of premium paid above the face value of a bond.

• Such a bond is said to trade at a premium, and the tax laws allow you to amortize the bond’s premium between the time you purchase it and its maturity date in order to offset your income.
• 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.
• Then, figure out how many months are left before the bond matures and divide the bond premium by the number of months remaining.
• Accountants can use either the straight-line method or the effective interest method to amortize the bond discount or premium.
• Any excess amount paid for a bond which is over and above its face value is amortizable bond premium.
• Regardless of the method that you apply as an accountant, the discount is amortized by debiting the Investment in Bonds account.

Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check. A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.

Amortization of Bonds Premiums & Discounts:

As the bond reaches maturity, the premium will be amortized over time, eventually reaching $0 on the exact date of maturity. A bond is a type of fixed-income investment that represents a loan made from a lender (investor) to a borrower. It is an agreement to borrow money from the investor and pay the investor back at a later date.

For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond. Regardless of the method that you apply as an accountant, the discount is amortized by debiting the Investment in Bonds account. The premium is amortized by crediting the Investment in Bonds account. Thus, the bond premium to be amortized yearly under this method comes to $560,000.

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This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period. How to use the straight-line method Calculating bond premium amortization using the straight-line method couldn’t be simpler. First, calculate the bond premium by subtracting the face value of the bond from what you paid for it.

The face value of a bond is also called “par value”, it is the original cost of a stock or the amount paid to the holder of a bond. Amortizable Bond Premium is the difference (excess premium) between the amount a bond is purchased and the face value/par value of the bond. Any excess amount paid for a bond which is over and above its face value is amortizable bond premium. This $417 consists of 4 months’ cash interest plus $17 of the amortized discount.

Bond Pricing

The yield to maturity is the discount rate that equates the present value of all coupons and principal payments to be made on the bond to its initial purchase price. A method of amortizing a bond premium is with the constant yield method. The constant yield method amortizes the bond premium by multiplying the purchase price by the yield to maturity at issuance and then subtracting the coupon interest.

• In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium.
• A bond is a type of fixed-income investment that represents a loan made from a lender (investor) to a borrower.
• Bond Premiums – Bonds that are issued at a price that is greater than its par value will be considered bonds issued at a premium.
• You should amortize the entire amount from the transaction in one period.
• This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month.
• This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond.

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. 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 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.

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Bonds that result in a premium or a discount should be amortized by either applying the effective interest method or the straight-line method. For your exam, it is very important that you understand how to calculate the periodic amortization expense that will be applied to the premium or the discount. Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date.

Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense. The constant-yield method will give you a smaller amortization amount than the straight-line method in early years, with the constant-yield amortization figure growing in later years. That puts it at a overall disadvantage to the straight-line method from the taxpayer’s standpoint, which might be one reason why tax laws were changed to have newer bonds use the less favorable method. For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount.