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.

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, accounts receivable vs payable: differences and definition 2023 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.

• 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.
• In both cases, the closer to the maturity date, the closer the interest expense gets to the par value of the bond.
• In addition, amortization reduces the duration of the bond, which helps companies better control the interest expense.
• For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly.
• Let’s assume that the corporation prepares a $100,000 bond with an interest rate of 9%.
• Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.

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.

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.

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Because the purchase price of bonds can vary so widely, the actual rate of interest paid each year also varies. 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. The issuer must make interest payments of $3,000 every six months the bond is outstanding. Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision. Based on the discounted future cash flows of the $300,000 bonds that have been issued, the effective interest rate can be calculated to be 6.9018% per annum.

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.

What is the difference between amortizing a discount and amortizing a premium?

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 Amortization of Bond Discount?

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 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.

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.

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.

Amortizing the Bonds Discount or Premium FAQs

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.

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.

Bond discount amortization schedule

Using this example, one can see that a discount bond has a positive accrual; in other words, the basis accretes, increasing over time from $0.19, $0.20, and so on. Periods 3 to 10 can be calculated in a similar manner, using the former period’s accrual to calculate the current period’s basis. In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation. Likewise, at the end of the maturity of the bond, the $12,000 of the bond premium will become zero. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month.