How to Amortize a Bond Premium Using the Straight-Line Method The Nest

Your choices regarding the treatment of bond premium depend on whether the bonds are taxable or nontaxable. Accrued interest on nontaxable bonds (e.g. municipal bonds) is not deductible and would simply reduce the nontaxable interest reported on line 8b of Schedule B. Is calculated as the annual interest amount by multiplying the face value of the bond on the payment date by the Interest Rate. Then this number is converted into a value relative to the payment periods. Since the bond has a life of 5 years, the annual amortization of bond discount would equal $1,516 ($7,580 divided by 5). In case of a discounted bond issue, the carrying amount equals face value minus the discount on bond; and in case of a premium issue, the carrying amount equals face value plus unamortized premium.

The price of the bonds is based on the present value of these future cash flows. The principal and interest amounts are based on the face amounts of the bond while the present value factors used to calculate the value of the bond at issuance are based on the market interest rate of 10%. Given these facts, the purchaser would be willing to pay $10,000, or the face value of the bond, as both the coupon interest rate and the market interest rate were the same. The total cash paid to investors over the life of the bonds is $20,000, $10,000 of principal at maturity and $10,000 ($500 × 20 periods) in interest throughout the life of the bonds. Electing not to amortize bond premiums on covered taxable bonds can cause issues with basis reporting.

For example, if there are 10 payments left and the interest is $4,500 per payment, then the total value of the interest payments https://www.bookstime.com/ is $45,000 or $4,500 x 10. You need to know how much money you’ll receive with every interest during the life of the bond.

Report your result as a line item called “Less unamortized discount” below the “Bonds payable” line item in the long-term liabilities section of your balance sheet. In this example, report “Less unamortized discount $900.” Reduce the unamortized discount by the annual amortization and report this line annually until the bond matures. 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. In this case, you’ll credit bond premium account for $4,100.Note that the complete accounting from this step and the previous one keeps your books in balance. You’ve debited cash for $104,100 and you’ve credited two accounts for $104,100 ($100,000 + $4,100).

Methods of Amortization of Bond Premium Calculation

The first term is the fixed interest payment, which in the example is $45,000. The second term is the prevailing semi-annual rate at the time of issue, which is 4 percent in the example, times the previous period’s book value of the bonds. The initial book value is equal to the bond premium balance of $41,000 plus the bond’s payable amount of $1 million.

After nine repetitions, the discount is zero and the book value is $1 million. When the coupon rate on a bond is lower than the market interest rate, the bond is issued at a discount to par value.

Reporting Amortization of a Premium

The interest expense in column C is the product of the 4% market interest rate per semiannual period times the book value of the bond at the start of the semiannual period. Notice how the interest expense is decreasing with the decrease in the book value in column G.

Of this paragraph , this same amount would be taken into income at the same time had A used annual accrual periods. Since the coupon rate is paid semi-annually, it means that every six months, a coupon of $25 ($1,000 x 5/2) will be paid. Also, the yield to maturity is stated in annual terms, so semi-annually the yield to maturity is 1.945% (3.89% / 2).

Straight-line Vs. Mortgage Style Amortization

A holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period. This offset occurs when the holder takes the qualified stated interest into account under the holder’s regular method of accounting. The premium account balance represents the difference between the cash received and the principal amount of the bonds. The premium account balance of $1,246 is amortized against interest expense over the twenty interest periods. Unlike the discount that results in additional interest expense when it is amortized, the amortization of premium decreases interest expense. The total interest expense on these bonds will be $10,754 rather than the $12,000 that will be paid in cash. This document contains final regulations that provide guidance on the tax treatment of a debt instrument with a bond premium carryforward in the holder’s final accrual period.

This correlation between the interest expense and the bond’s book value makes the effective interest rate method the preferred method. In simple words, expenses decrease with a decrease in book value under the Effective Interest rate method. This logic seems practical, but the straight-line method is easier to calculate. If the primary consideration is to defer current income, the Effective Interest rate method should be chosen to amortize the premium on bonds. The Straight Method is preferable when the premium amount is very less or insignificant. The bond’s maturity period is 10 years, and the face value is $20,000.

Level 1 CFA® Exam: Amortizing Bond Discount or Premium

Recalculate the book value of the bond for the next interest payment. The new book value of the bond is the previous book value minus the debit to the bond premium account. So, for your first interest payment, the previous book value of the bond was $104,100 in the current example. The new book value is $103,764 or $104,100 – $336.The new book value is what you’ll use to calculate the interest expense the next time that you receive an interest payment. The bond premium allocable to an accrual period is determined under this paragraph .

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Bond Pricing

The taxpayer should weigh the relative costs and benefits of each approach. In making this choice, if the taxpayer must determine the amount of amortization, this will require information from the broker, a potentially difficult process that requires the brokers’ cooperation. For non-covered taxable bonds, the Form 1099 will likely not report amortization, and for covered taxable bonds, the broker might provide interest net of amortization. Even if amortization is provided, it likely will be a single figure for all taxable bonds and not be detailed for each bond held. The basis of taxable bonds will also have to be calculated for non-covered taxable bonds. If you issue a bond at other than its face, or par, value, you must amortize the difference between the issue price and par. A premium bond sells for more than par; discount bonds sell below par.

Remember, though, you’ll use the face value of the bond to calculate the interest payments, not the amount that you paid for the bond. For example, if the you bought a bond for $104,100 with a face value of $100,000, then the premium is $4,100 or $104,100 – $100,000.The bond premium is the amount you’ll amortize over the life of the bond.

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. You may also want to consult your company’s counsel on the matter.

• It debits a non-current asset called debt issue costs when it records the credit to the bonds payable account.
• Then this number is converted into a value relative to the payment periods.
• The premium account balance represents the difference between the cash received and the principal amount of the bonds.
• See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization .

The taxpayer should attach a statement to his or her income tax return to make the election to amortize taxable bond premiums. Absent this affirmative election, an IRS representative has indicated that the current unofficial position of the IRS is that simply reporting interest net of amortization is sufficient to elect amortization. Taxpayers and their preparers likely will not want to rely on an unofficial position, so care must be taken in reporting interest income.

Understanding Amortized Bonds

Corporations holding bond investments credit the bond investment account — a long-term asset — and debit interest expense when they recognize amortization at month’s end. The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page. The flip side of a bond premium is a discount — the excess of face value over bond price.

Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at amortizing bond premium a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant. The effective interest rate method uses the market interest rate at the time that the bond was issued.

Watch It: Bonds Issued at a Discount

Premium BondsA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value. This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest. For instance, a bond with a face value of $750, trading at $780, will reflect that the bond is trading at a premium of $30 ($ ).

• The interest expense is amortized over the twenty periods during which interest is paid.
• You need to know how much money you’ll receive with every interest during the life of the bond.
• Recalculate the book value of the bond for the next interest payment.
• This will be easy to retrieve because you’ll be given the yield at time of purchase.You can also calculate current yield by dividing the annual cash flows earned by the bond by the market price.
• The bonds have a term of five years, so that is the period over which ABC must amortize the premium.
• Is calculated as the annual interest amount by multiplying the face value of the bond on the payment date by the Interest Rate.

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 effective interest method, which is used when the effects of amortization are material, results in a constant rate of interest on the carrying value of the bonds. To find interest and the amortization of discounts or premiums, the effective interest rate is applied to the carrying value of the bonds at the beginning of the interest period. The amount of the discount or premium to be amortized is the difference between the interest figured by using the effective rate and that obtained by using the face rate. Any amount you cannot deduct because of this limit can be carried forward to the next accrual period. 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 constant yield method is used to determine the bond premium amortization for each accrual period. 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.