12 Apr Amortizing Bond Premium Using the Effective Interest Rate Method
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. As mentioned earlier, if market interest rates fall, any given bond with a fixed coupon rate will appear more attractive, and it will result in the bond trading at a premium.
So, if a bond comes with a face value of $1,000, and is trading at $1,080, it offers an $80 premium. Then, the company issuing such bonds needs to write off the bond’s Premium over its life in the books of accounts. Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life. By reducing the bond premium to $0, the bond’s book value will be decreasing from $104,100 on January 1, 2022 to $100,000 when the bonds mature on December 31, 2026.
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Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 241,337 representing a market rate of 12%. Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 259,075 representing a market rate of 8%. The effective interest method is a more accurate method of amortization, but also calls for a more complicated calculation, since it changes in each accounting period. This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results.
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- The bond’s carrying value at the end of the period in Column 6 is reduced by the premium amortization for the period.
- As mentioned earlier, if market interest rates fall, any given bond with a fixed coupon rate will appear more attractive, and it will result in the bond trading at a premium.
- The table is commonly used by the issuers of bonds to assist them in accounting for these instruments over time.
- For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market.
The effective interest method is one method of calculating how the premium or discount on bonds payable should be amortized to the interest expense account over the lifetime of the bond. When they are issued at anything other https://www.wave-accounting.net/nonprofit-accounting-best-practices-and-essential/ than their par value a premium or discount on bonds payable account is created in the bookkeeping records of the business. The bonds have a term of five years, so that is the period over which ABC must amortize the premium.
The Effective Rate Method
Reducing the bond premium in a logical and systematic manner is referred to as amortization. At the end of your fifth year of payments, the monthly How to do bookkeeping for startup payment figure remains the same. Still not much toward a total principal loan balance of $200,000 but making some progress in retiring the debt.
Based on your chosen method, you can amortize the bond premium in the books of accounts. Interest expense is calculated as the effective-interest rate times the bond’s carrying value for each period. The amount of amortization is the difference between the cash paid for interest and the calculated amount of bond interest expense. 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, its effective interest rate would sink to 5%.
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With the effective interest method, as with the straight-line method, the total interest expense is $67,024. Importantly, there is no difference in the total interest expense within the 5-year period of time; there is only a difference in the allocation. Under the effective interest method, the semiannual interest expense is $6,508 in the first period and increases thereafter as the carrying value of the bond increases. The difference between the required cash interest payment of $6,000 in Column 3 ($100,000 x 6%) and the effective interest expense of $6,508 is the required discount amortization of $508 in Column 4. Thus, the bond premium to be amortized yearly under this method comes to $560,000. While the Effective Interest Rate method provided in DebtBook is the “correct” approach per the standard, we know in practice many issuers utilize the “Straight-Line” method when calculating their premium/discount amortization.
A bond amortization schedule is a table that shows the amount of interest expense, interest payment, and discount or premium amortization of a bond in each successive period. The table is commonly used by the issuers of bonds to assist them in accounting for these instruments over time. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 250,000, and the discount on bonds payable (8,663) has been amortized to interest expense. As before, the final bond accounting journal would be to repay the face value of the bond with cash. 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 250,000, and the premium on bonds payable (9,075) has been amortized to interest expense.
The schedule below shows how the premium is amortized under the effective interest method. Although the straight-line method is simple to use, it does not produce the accurate amortization of the discount or premium. Different Types of Revenue and Profits for Startup Accounting This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.