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Therefore, the bond discount of $5,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond. The effective interest method is an accounting practice used to discount a bond. This method is used for bonds sold at a discount or premium; the amount of the bond discount or premium is amortized to interest expense over the bond’s life. Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.
- The table is commonly used by the issuers of bonds to assist them in accounting for these instruments over time.
- Knowing this, you’ll notice that the straight line method will result in more discount or premium amortization during earlier years than the effective interest method.
- For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market.
- The amortization amount is calculated by dividing the value of the amortization premium by its life.
- A bond trading for less than 100 would be priced for less than $1,000; it is considered a discount.
The company chose to create a premium account, rather than write off the difference in Cash Flows over the life of the bond since it would like to maintain its financial leverage. The effect of this and subsequent entries is to decrease the carrying value of the bonds. The key difference is that the cash flows are discounted at the semi-annual yield rate of 5%.
Part 2: Your Current Nest Egg
Based on your chosen method, you can amortize the bond premium in the books of accounts. 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. The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method.
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. 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. When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back.
Amortization of Bonds Premiums & Discounts:
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. As indicated in Example 1 of this paragraph (c), this same amount would be taken into income at the same time had A used annual accrual periods. The initial journal entry to record the issuance of the bonds, and the final journal entry to record repayment at maturity would be identical to those demonstrated for the straight-line method.
Thus, the company will record $9,000 of interest expense, of which $8,000 is cash and $1,000 is the amortization of the discount. We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan. An amortization table calculates the allocation of interest and principal for each payment and is used by accountants to make journal entries. Prepare a law firm bookkeeping for the first 4
interest periods. Under § 1.1016–5(b), C’s basis in the obligation is reduced by $2,420.55 on January 15, 2000.
