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According to the effective interest rate method, the adjustment reflects the reality better. In other words, it reflects what the change in the bond price would be if we assumed that the market discount rate doesn’t change. When bonds are sold at a discount or a premium, the interest rate is adjusted from the face rate to an effective rate that is close to the market rate when the bonds were issued.
Investors only demand an 8% return for owning the bond, and thus pay the company $106,710.08 for the bonds. For discount bonds, in the consecutive years, we will adjust the historical cost up until we reach the bond’s par value and for premium bonds we will adjust the historical cost down until we reach the par value. However, the straight-line method assumes that in each period throughout the bond’s life the value of the adjustment is the same.
Issuance of Bond at Premium
It is an agreement to borrow money from the investor and pay the investor back at a later date. This method relates the interest expense for the period to the bond’s book value. The amount of interest decreases with a decrease in the bond’s book value. We will solve the problem assuming first the effective interest rate method, and then the straight-line method. We will illustrate the problem by the following example related to a premium bond.
Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes. A bond trading for less than 100 would be priced for less than $1,000; it is considered a discount. A bond trading for more than 100 would be priced for more than $1,000; it is considered a premium. Under US GAAP both straight line and effective interest method are allowed but the effective interest method is preferred.
What is an Amortizable Bond Premium?
In this case, the company can make a lump sum payment rather than several smaller payments. This leads to saving in interest costs and also helps in making a smooth transition from one accounting period to another. Further, companies can pick up the coupon payments in advance law firm bookkeeping and reduce their interest costs. Another way to calculate the $6,702 is to divide the total interest cost, $67,024, into the 10 interest periods of the bond’s life, as in the journal entry for 1 July 2020. The interest payments on the obligation are qualified stated interest.
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Amortization of Bond Premiums and Bond Discounts:
To illustrate, the relevant T-accounts and a partial balance sheet as of 1 July 2020 are presented below. The Effective Interest Rate method compares a bond’s Face Value Stated Interest to the bond’s Book Value Effective Interest, let’s walk through what each of these terms mean and how they are calculated using our Series information pictured below. Generally, a bond will come with a face value of $1,000 or some other round number. However, the actual price paid to purchase the bond usually is not $1,000. Based on market conditions, the price could be less than or greater than $1,000. A bond is a type of fixed-income investment that represents a loan made from a lender (investor) to a borrower.
However, the amount of interest expense reported in the income statement will differ from this value depending on whether the bond is issued at par, discount or premium. Solve for present value to get $93,855.43, or the amount investors will pay for these bonds if they want a 10% annual return, also known as a yield to maturity. As you can see, according to the straight-line method the amortization of premium is the same for all periods. However, for the effective interest rate method, the amortization of premium is greater as time passes by. Note that for premium bonds the interest payment is always greater than the interest expense and the difference between them is the amortization of premium. On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000).
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. If a company’s profits are unstable, it may choose to use this method of amortization which will help them avoid paying tax on periodic basis. For 1999, A includes in income $8,141.68, the qualified stated interest allocable to the period ($9,166.67) offset with bond premium allocable to the period ($1,024.99). Under § 1.1016–5(b), A’s basis in the bond is reduced by $1,024.99 in 1999. The bond premium allocable to an accrual period is determined under this paragraph (a)(3).
- Each year, the company will have to pay $8,000 in cash interest (coupon rate of 8% X $100,000 in face value).
- For example, consider an investor that purchased a bond for $10,150.
- 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.
- In the first period, we record $93,855.43 as the carrying amount of the bond.
- Under the straight line method, the premium or discount on the bond is amortized in equal amounts over the life of the bond.