Of course, we can use some tools to calculate the effective interest rate such as the excel spreadsheet where we can calculate the effective interest rate using the IRR() formula. In any case, we still need to make the journal entry for amortization of bond discount or bond premium in order to make the carrying value of the bonds payable equal to the face value of the bond at the end of the bond maturity. Based on the remaining payment schedule of the bond and A’s basis in the bond, A’s yield is 7.92 percent, compounded semiannually. Therefore, the bond premium allocable to the accrual period is $645.29 ($5,000−$4,354.71). Although the accrual period ends on August 1, 1999, the qualified stated interest of $5,000 is not taken into income until February 1, 2000, the date it is received.
This method involves dividing the total bond premium by the number of years until maturity and amortizing the same amount each year. This $417 consists of 4 months’ cash interest plus $17 of the amortized discount. Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense. This procedure ensures that after the discount or premium is fully amortized, the investment account will reflect the bond’s maturity value. Therefore, the sum of all amounts payable on the obligation (other than the interest payments) is $100,000.
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Each year, bondholders receive IRS tax Form 1099-INT or Form 1099-OID to report their annual taxable interest income when filing tax returns. This document offers guidelines for declaring tax on income generated from interest and bond taxation rules for government, corporate, and municipal bonds vary. Using the straight-line method, we can amortize the $12,000 bond premium to be $4,000 per year for each of the three years of bond periods. Using the straight-line method, we can amortize the $15,000 bond discount by dividing it by the 3 years life of the bonds which gives the result of $5,000 per year. The following T-account shows how the balance in the account Premium on Bonds Payable will decrease over the 5-year life of the bonds under the straight-line method of amortization. In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank.
- It is an agreement to borrow money from the investor and pay the investor back at a later date.
- Amortization is the process of separating the principal and interest in the loan payments over the life of a loan.
- A corporate bond is a type of debt security issued by a corporation to raise capital and then sold to investors.
- The amortization can be done equally in each accounting period up to the end of the bond’s life.
The amount received for the bond (excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on bonds payable, bond premium, or premium. To calculate the amortizable bond premium using the constant yield method, multiply the bond’s adjusted cost basis by its effective interest rate and subtract the annual interest payment. On February 1, 1999, A purchases for $110,000 a taxable bond maturing on February 1, 2006, with a stated principal amount of $100,000, payable at maturity. The bond provides for unconditional payments of interest of $10,000, payable on February 1 of each year. A uses the cash receipts and disbursements method of accounting, and A decides to use annual accrual periods ending on February 1 of each year. This is because the carrying value of bonds payable equal bonds payable minus bonds discount or the bonds payable plus bond premium.
Definition of Amortizable Bond Premiums
One needs to calculate the number of bond premiums to amortize bond premiums. The same can be calculated by reducing the face value of the bond from its issue price. As a result, we can see that there is a small difference between the amortization of bond discount using the straight-line method and the one using the effective interest rate method. Hence, we need to make the amortization of the bond discount in order to have the carrying value of bonds payable equaling the face value of the bond at the end of the bond maturity. In this case, the carrying value of the bonds payable on the balance sheet will equal bonds payable minus the bond discount. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes.
It makes the bond more attractive, and it is why the bond is priced at a premium. When market interest rates rise, for any given bond, the fixed coupon rate is lower relative to other bonds in the market. It makes the bond more unattractive, and it is why the bond is priced at a discount. For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.
The bond is dated as of January 1, 2022 and has a maturity date of December 31, 2026. The bond’s interest payment dates are June 30 and December 31 of each year. This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12). The effective interest rate calculation reflects actual interest earned or paid over a specified timeframe. In order to calculate the premium amortization, you must determine the yield to maturity (YTM) of a bond.
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The amortization amount is calculated by dividing the value of the amortization premium by its life. Typically companies make an amortization table for the amortization of bond premiums each year. The amortizable bond premium refers to the excess price paid for a bond above its face value.
Amortizing the Bond
Bonds issued by well-run companies with excellent credit ratings usually sell at a premium to their face values. Since many bond investors are risk-averse, the credit rating of a bond is an important metric. In the case of a tax-exempt obligation, if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is a nondeductible loss.
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. To account for the premium paid on a bond, the investor has the option to amortize or spread out the deduction of the premium over the remaining term of the bond. 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.
At the end of the 3rd year, the $15,000 bond discount will be become zero ($15,000 – $5,000 – $5,000 – $5,000) and the carrying value of the bonds payable will equal $500,000 ($500,000 – $0). Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life.
As an example let’s say that Apple Inc. (AAPL) issued a bond with a $1,000 face value with a 10-year maturity. The interest rate on the bond is 5% while the bond has a credit rating of AAA from the credit rating agencies. Conversely, as interest bonds meaning rates rise, new bonds coming on the market are issued at the new, higher rates pushing those bond yields up. DebtBook also offers another acceptable form of the Effective Interest method that takes into account the callability of maturities.
The Investment in Bonds account is debited for four months of discount amortization. The total discount is $240 and is amortized over the remaining 58 months of the bond’s life at the time of issue. As is to be expected, the calculation for Straight-Line is more straightforward than the Effective Rate Method outlined above. In the case of Straight-Line, the total net premium/discount is simply divided by the number of days from the dated date, to the final maturity date, thereby generating a level or “Straight-Line” amortization across the life of the bonds.