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Under this method, the amount of bond premium is equally amortized each year or accounting period. 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.
For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes. Bond Premiums – Bonds that are issued at a price that is greater than its par value will be considered bonds issued at a premium.
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Amortizing Bond Premium with the Effective Interest Rate Method
Just like with a discount, the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual interest payment. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2. One big caveat about the straight-line method 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. As IRS Publication 550 states, for bonds issued after Sept. 27, 1985, taxpayers must amortize bond premium using the constant-yield method, which differs from the straight-line method. For older bonds issued before Sept. 27, 1985, the straight-line method is still an option.
Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes. 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.
Bonds Issued at a Discount
Additionally, bonds that are issued at a premium will be those with a market rate that is less than the bonds stated rate. Bond Discounts – Bonds that are issued at a price that is less than its par value will be considered bonds issued at a discount. Additionally, bonds that are issued at a discount will be those with a market rate that is greater than the bonds stated rate. Suppose the company issues 2000 bonds for $ 22,800 each, and the face value of the bonds is $ 20,000.
This equals $4.14 ($240 + 58 months — $4.14) per month, and 4 months’ amortization from 1 March 2020 to 1 July 2020 is $16.56 ($4.14 x 4). 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. 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. Generally, a bond will come with a face value of $1,000 or some other round number.
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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. This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium. 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. The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.
- The discount will increase bond interest expense when we record the semiannual interest payment.
- Understanding how bond premiums and discounts will be calculated and recognized on the financial statements will be critical to your understanding of this topic.
- However, the actual price paid to purchase the bond usually is not $1,000.
- The bonds are to be redeemed after a period of 10 years at face value.
- Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.
The bonds have a term of five years, so that is the period over which ABC must amortize the premium. The second way to amortize the premium is with the effective interest method. 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.
In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a bond premium every year. In order to calculate the premium amortization, you must determine the yield to maturity (YTM) of a bond.
Then, figure out how many months are left before the bond matures and divide the bond premium by the number of months remaining. When we issue a bond at a premium, we are selling the bond for more than it is worth. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable.
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She has worked in multiple cities covering breaking news, politics, education, and more. In this entry, Cash is debited for $600, which is the full 6 months’ interest payment ($12,000 x 0.05). In practice, if there are material differences between the https://accounting-services.net/should-i-recognize-a-bond-premium-amortization-on/ two methods, the effective interest method should be used. However, for ease of illustration, the straight-line method is used in this article. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month.
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. When a company issues bonds, investors may pay more than the face value of the bonds when the stated interest rate on the bonds exceeds the market interest rate. If so, the issuing company must amortize the amount of this excess payment over the term of the bonds, which reduces the amount that it charges to interest expense.
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