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When a consumer borrows money, she can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan.
The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then the interest earned will decline also. The preferred method for amortizing (or gradually expensing the discount on) a bond is the effective interest rate method. Under this method, the amount of interest expense in a given accounting period correlates with the book value of a bond at the beginning of the accounting period.
The Rationale Behind the Effective Interest Rate
Under the effective interest method, the interest expense is calculated by multiplying the carrying value of the liability at the beginning of the period by the bond’s yield at issuance. Solve for present value to get $106,710.08, or the amount investors will pay for these bonds assuming they want an annual return of 8%, also known as a yield to maturity. In the first period, we record $93,855.43 as the carrying amount of the bond.
Knowing this, you’ll notice that the straight line method will result in more discount or premium amortization during earlier years than the effective interest method. Conversely, the effective interest method results in more amortization in later years than the straight line law firm bookkeeping method. When the bond matures, however, there should be no difference at all in the total amount of cash interest, interest expense, or amortization between the two methods for the same bond. Suppose the company issued $100,000 of 10-year bonds that pay an 8% annual coupon.
Methods for Amortizing Premium/Discount
Based on the remaining payment schedule of the obligation and C’s basis in the obligation, C’s yield is 5.48 percent, compounded annually. Therefore, the bond premium allocable to the accrual period is $2,420.55 ($9,000−$6,579.45). Therefore, the adjusted acquisition price on August 1, 1999, is $114,354.71 ($109,354.71 + $5,000). Therefore, the bond premium allocable to the accrual period is $472.88 ($5,000−$4,527.12). Based on the remaining payment schedule of the bond and A’s basis in the bond, A’s yield is 8.07 percent, compounded annually.
But the company is only paying interest on $100,000—not on the full amount received. The difference in the sale price was a result of the difference in the interest rates so both rates are used to compute the true interest expense. The remaining amounts of qualified stated interest and bond premium allocable to the accrual period ending on February 1, 2000, are taken into account for the taxable year ending on December 31, 2000. In the case of a tax-exempt obligation, if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is a nondeductible loss. (C) Carryforward in holder’s final accrual period—(1) Bond premium deduction.
Watch It: Bonds Issued at a Discount
We will illustrate the problem by the following example related to a premium bond. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. The relevant T accounts, along with a partial balance sheet as of 1 July 2020, are presented below.
- Amortization is the process of separating the principal and interest in the loan payments over the life of a loan.
- Our calculations have used what is known as the effective-interest method, a method that calculates interest expense based on the carrying value of the bond and the market interest rate.
- The primary advantage of using the effective interest rate is simply that it is a more accurate figure of actual interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage.
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- Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate.
- Therefore, the bond premium allocable to the accrual period is $645.29 ($5,000−$4,354.71).
An overview of these methods, using discount and premium examples, is given below. The table below shows how to determine the price of Valenzuela Corporation’s 5-year, 12% bonds issued to yield. To illustrate, consider the following balance sheet from Valenzuela Corporation prepared on 2 January 2020 immediately after the bonds were issued. Suppose that on 2 January 2020, Valenzuela Corporation issued $100,000, 5-year, 12% term bonds. Under the straight-line method, bond premium is amortized equally in each period. Companies do not always issue bonds on the date they start to bear interest.
Bond Amortization, Interest Expense, and Interest Payments
Let’s calculate the amortization for the first period and second period. In order to calculate the premium amortization, you must determine the yield to maturity (YTM) of a bond. 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.
