Premium Discount Amortization Methodology Explained

To find interest and the amortization of discounts or premiums, the effective interest rate is applied to the carrying value of the bonds at the beginning of the interest period. The amount of the discount or premium to be amortized is the difference between the interest figured by using the effective rate and that obtained by using the face rate. As in the SLA discount bond example, the initial book value is equal to the bond’s payable amount of $1 million minus its discount of $38,500, or $961,500. After six months, you make the first interest payment of $45,000.The interest expense of $48,075 is 5 percent — the semi-annual interest rate — of the book value. You credit the bond discount by the difference of the $48,075 interest expense minus the $45,000 interest payment, or $3,075, reducing the discount to $35,425. After nine repetitions, the discount is zero and the book value is $1 million.

• As we amortize the premium/discount over the life of the bond, the book value is reduced back to its original par amount at either the maturity date or the call date, again depending on how the bond is priced.
• Based on your chosen method, you can amortize the bond premium in the books of accounts.
• Such a bond is said to trade at a premium, and the tax laws allow you to amortize the bond’s premium between the time you purchase it and its maturity date in order to offset your income.
• Now that we’ve established to which date we’ll be amortizing our premium or discount, we can walk through the calculation.
• As simple as the straight-line method is, the main problem with it is that the IRS generally doesn’t allow you to use it anymore.
• When we issue a bond at a premium, we are selling the bond for more than it is worth.

For available for sale securities, any catch-up of amortization also affects the unrealized gain or loss. Banks should consider and record the appropriate tax effects with https://www.bookstime.com/ these entries as well. Remember, the premium is the difference between what you paid for a bond and the total of all amounts payable on the bond through redemption.

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That value is the interest expense used in the straight line method.. Bonds PayableBonds payable are the company’s long-term debt with the promise to pay the interest due and principal amortizing bond premium at the specified time as decided between the parties. A bond payable account is credited in the books of accounts with the corresponding debit to the cash account on the issue date.

Discuss the differences between the different methods of depreciation. Explain the differences between depreciation expense and the accumulated depreciation. To calculate the Book Value Effective Interest, the Outstanding Book Value on a maturity is multiplied by that maturity’s yield. In case of bonds held by an estate or trust, the election authorized under this subsection shall be exercisable with respect to such bonds only by the fiduciary. Becomes applicable with respect to the taxpayer with respect to such bond.

Explain the two methods to amortize the bond premium and discount. Give example journal entries…

The bond’s maturity period is 10 years, and the face value is $20,000. The coupon rate of interest is 10% and has a market rate of interest at 8%. The premium paid for a bond represents part of the cost basis of the bond, and so can be tax-deductible, at a rate spread out over the bond’s lifespan. Explain what is meant by an accelerated depreciation method.

• For your exam, it is very important that you understand how to calculate the periodic amortization expense that will be applied to the premium or the discount.
• Therefore, the bond premium allocable to the accrual period is $645.29 ($5,000−$4,354.71).
• He has over 40 years of experience in business and finance, including as a Vice President for Blue Cross Blue Shield of Texas.
• It is important to record accretion and amortization in chronological order if you are having Fund Manager do the calculation for you.
• What accounts are affected when recording the issue date of a discount bond?

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 decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing.

Bond Amortization Methods

You may elect to record your own amounts for accretion or amortization, or have Fund Manager calculate the amounts for you. Fund Manager uses the “constant yield” method to calculate the amounts of accretion or amortization. You can either specify the YTM to use in the calculation, or have Fund Manager calculate the YTM of your bond for you. For tax-exempt bonds, on the other hand, under IRS rules the holder must assume the lower yield scenario, which generally means amortizing to the earliest call date, rather than maturity. In that case, the ASU approach also will be correct for tax purposes.

When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding. In the example above, if Janice did not elect to amortize the premium, then at maturity there would be a $30 long-term capital loss (sales proceeds of $1,000 less $1,030 paid for the bond).

Level 1 CFA® Exam: Amortizing Bond Discount or Premium

For example, suppose your company issues a $1 million par value bond for $1.041 million that matures in 5 years. The bond pays 9 percent interest, or $4,500 semiannually, while the prevailing annual interest rate is only 8 percent. At issue, you debit cash for the $1.041 million sale proceeds and credit bonds payable for $1 million face value. You plug the $41,000 difference by crediting the adjunct liability account “premium on bonds payable.” SLA reduces the premium amount equally over the life of the bond.

You debit the bond premium by the $45,000 interest payment minus the $41,640 interest expense, or $3,360, reducing the premium to $37,640. Repeat the cycle nine more times — the book value ends at $1 million and the premium is gone. You collect a premium when you issue bonds bearing an interest rate higher than prevailing rates.