This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period. How to use the straight-line method Calculating bond premium amortization using the straight-line method couldn’t be simpler. First, calculate the bond premium by subtracting the face value of the bond from what you paid for it.
Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first https://accounting-services.net/should-i-recognize-a-bond-premium-amortization-on/ six months’ interest check. A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.
Watch It: Bonds issued at a premium
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. A method of amortizing a bond premium is with the constant yield method. The constant yield method amortizes the bond premium by multiplying the purchase price by the yield to maturity at issuance and then subtracting the coupon interest.
For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond. Regardless of the method that you apply as an accountant, the discount is amortized by debiting the Investment in Bonds account. The premium is amortized by crediting the Investment in Bonds account. Thus, the bond premium to be amortized yearly under this method comes to $560,000.
What is the Effective Interest Method for Amortizing Bond Discounts and Bond Premiums?
The face value of a bond is also called “par value”, it is the original cost of a stock or the amount paid to the holder of a bond. Amortizable Bond Premium is the difference (excess premium) between the amount a bond is purchased and the face value/par value of the bond. Any excess amount paid for a bond which is over and above its face value is amortizable bond premium. This $417 consists of 4 months’ cash interest plus $17 of the amortized discount.
- 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.
- The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method.
- First, calculate the bond premium by subtracting the face value of the bond from what you paid for it.
- A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates.
- Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value.
Bonds that result in a premium or a discount should be amortized by either applying the effective interest method or the straight-line 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. Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date.
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Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense. The constant-yield method will give you a smaller amortization amount than the straight-line method in early years, with the constant-yield amortization figure growing in later years. That puts it at a overall disadvantage to the straight-line method from the taxpayer’s standpoint, which might be one reason why tax laws were changed to have newer bonds use the less favorable method. For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount.
As the bond reaches maturity, the premium will be amortized over time, eventually reaching $0 on the exact date of maturity. A bond is a type of fixed-income investment that represents a loan made from a lender (investor) to a borrower. It is an agreement to borrow money from the investor and pay the investor back at a later date.