Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.
One of the biggest misconceptions surrounding amortizing discounts and premiums is that they should never be negative. This is not the case; however, you must follow certain guidelines when it comes to reporting negative amounts on your balance sheet if you choose to take them into account in determining net income. Next, let’s assume that just prior to offering the bond to investors on January 1, the market interest rate for this bond increases to 10%.
- Lopez Co. has issued a bond equivalent to $10,000,000, for a time to maturity of 5 years.
- With the figures given above, the monthly payments are $1,073.64, which works out to be $12,883.68 per year.
- Most people are familiar with amortization if they have a fixed-rate mortgage.
- In this journal entry, the carrying value of the bonds payable on the balance sheet is $485,000 as the $15,000 bond discount is a contra account to the $500,000 bonds payable.
This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. An interest-bearing asset also has a higher effective interest rate as more compounding occurs. For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.
Watch It: Bonds Issued at a Discount
If the discounted amount is material the company need to amortize the bond discount with the effective interest rate method as it is a more accurate method compared to the straight-line method. Likewise, we can make the journal entry for the amortization of bond discount by debiting the interest expense account and crediting the bond discount account. The interest on carrying value is still the market rate times the carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of discount amount is added to the carrying value. We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan.
Therefore, the amortization causes interest expense in each accounting period to be higher than the amount of interest paid during each year of the bond’s life. And the net accumulated loss is shown on the asset side in the balance sheet. is it an asset will increase the carrying value of the bonds payable on the balance sheet from one period to another until it equals the face value of the bond at the end of the bond maturity. After all, at the end of the bond maturity, the balance of the unamortized bond discount will become zero. Discounted bonds’ amortization always leads to an effective interest expense that is higher than the payment of the bond interest coupon for each period. If a bond is sold at a discount, it means that the market interest rate is above the coupon rate. In this case, the amortization amount of the bonds’ discount for each period in the payment of the cash coupon is added to get the expense by real interest for net income calculation.
Bonds Payable Issued at a Discount
The company promised 5% when the market rate was 4% so it received more money. 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. Amortization is ultimately an accounting tactic that benefits an issuer when it comes time to filing taxes. An amortized bond’s discount is listed as a portion of the issuer’s interest expenses on its income statement.
How Accretion of Discount Works
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. The amortization process of bond discount takes place using the effective interest rate method.
Explanation of Amortization of Bond Discounts
The effective interest amortization method is more accurate than the straight-line method. International Financial Reporting Standards (IFRS) require the use of the effective-interest method, with no exceptions. Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable.
For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. 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.
Paying straight-line amortization of bond discount or premium over the life of the bond is very complicated and not recommended. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022. The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a contra-liability account called Discount on Bonds Payable.
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The effective interest rate method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative simpler method is the straight line method. A common factor between bond amortization and indirect cash flow method is that both of them involve interest expenses which are not in cash. In the indirect cash flow method, the expenses not in cash are adjusted to the net income (which is a profit in accounting that has expenses in cash and also not in cash). The change to the net income is either an addition or subtraction depending on the bond redemption type.
If inflation is 1.8%, a Treasury bond (T-bond) with a 2% effective interest rate has a real interest rate of 0.2% or the effective rate minus the inflation rate. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. 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.