In our example, the bond discount of $3,851 results from the corporation receiving only $96,149 from investors, but having to pay the investors $100,000 on the date that the bond matures. The discount of $3,851 is treated as an additional interest expense over the life of the bonds. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond). 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%. The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate.

• In the case where the bond issue took place right before the year-end, the bonds payable account, as well as the bonds payable account would be netted together.
• Still not much toward a total principal loan balance of $200,000 but making some progress in retiring the debt.
• Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.
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• This leads to the subtraction of the bonus amortization amount for each period of the coupon payment in cash to realize the real expense and calculate the net income.

Straight line amortization is a quick and convenient way of amortizing a bond, but it’s not always the most accurate or financially beneficial way for companies to approach bond amortization. However, it will also carry an additional present value of an ordinary annuity table expense for the bond discount—in this case, $175 per year. As is the case for something like depreciation, straight line bond amortization involves the same amount of interest expense each year over the life of the bond.

Bonds Payable

The effective interest rate calculation reflects actual interest earned or paid over a specified timeframe. It is not strange for a company to issue the bond at a discount, in which the selling price of the bond is lower than its face value. 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 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.

Treasury bond, although the same principles apply to corporate bond trades. When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interest rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value. For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market.

Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount. Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate. The coupon rate is the amount of interest generated by the bond each year, expressed as a percentage of the bond’s par value. After six months, the issuer will make interest payments amounting to $300,000 (10,000 × $1,000 × 6%/2). However, the interest expense will be higher than the coupon payments due to amortization of bond discount.

Bond Discount

In this scenario, the issuing party normally issues the bonds at a discounted rate. In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31. The entries for 2022, including the entry to record the bond issuance, are shown next.

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. Effective-interest method requires a financial calculator or spreadsheet software to derive. Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization.

Straight-Line Amortization of Bond Discount on Monthly Financial Statements

With the straight-line method, you are debiting more interest revenue each year until there is no remaining bond discount or premium. The effective interest method will allow you to record more interest revenue in early years and less interest revenue in later years. 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. The Investment in Bonds account is debited for four months of discount amortization.

Accretion of Discount: Meaning, Calculation

A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold. A common factor between bond amortization and indirect cash flow method is that both of them involve interest expenses which are not in cash.

It received $91,800 cash and recorded a Discount on Bonds Payable of $8,200. Using the same format for an amortization table, but having received $91,800, interest payments are being made on $100,000. The amortization of the bonus on bonds leads to an interest expense less than the payment of the bond’s coupon interest for each period. If a bond is sold at a premium, it means that the market interest rate is less than the coupon rate.

The bond traders are required to use the new amortized cost in case a bond in negotiated before its maturity. A premium or discount bonus sold above the amortized is subjected to tax no matter the original cost. Bonds that are sold below the amortized costs incur losses, and because of this, an essential concept of the exchange of taxes is utilized to avoid capital gains of the bonds. Exchange of taxes means that there are commercial ties with the losses of the same type of bonds to ensure the recognition of tax loss for purposes of income tax. 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.