If inflation is 1.8%, a Treasury bond (T-bond) with a 2% effective interest rate has a real interest rate of 0.2% or the effective rate minus the inflation rate. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. 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.

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. 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%.

2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

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. Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. 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.

For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. 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.

Bonus premiums show that there is a decline in interest rates from when the bond was issued. The prices of premium and discount bonds remain even when the interest rates don’t change until maturity. The reason why the bonds prices are similar is that these prices become convergent as the bonds near maturity. Majority of the bonds have early amortization characteristics for a specific date and price, and the premium bonuses amortize first to the call function.

• Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period.
• 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.
• We need to pay interest at the end of each year during the period of the bonds.
• Companies do not always issue bonds on the date they start to bear interest.
• Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases.

The company promised 5% when the market rate was 4% so it received more money. But the company is only paying interest on $100,000—not on the full amount received. The difference in the sale price was a result of the difference in the interest rates so both rates are used to compute the true interest expense. Amortization is ultimately an accounting tactic that benefits an issuer when it comes time to filing taxes. An amortized bond’s discount is listed as a portion of the issuer’s interest expenses on its income statement.

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. In this journal entry, the carrying value of the bonds payable on the balance sheet is $485,000 as the $15,000 bond discount is a contra account to the $500,000 bonds payable. The discount on bonds payable account has a debit balance of 8,663 which needs to be amortized to the interest expense account over the lifetime of the bond. Sellers can either accumulate the interest income in a suspense account and then close it at maturity, or they can use the proportionate method, which is to debit cash for the full interest expense on each coupon date.

What is the approximate value of your cash savings and other investments?

Paying straight-line what is a capital campaign or premium over the life of the bond is very complicated and not recommended. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022. The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. 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. 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 contra-liability account called Discount on Bonds Payable.

Understanding the Effective Interest Rate Method

If the discounted amount is material the company need to amortize the bond discount with the effective interest rate method as it is a more accurate method compared to the straight-line method. Likewise, we can make the journal entry for the amortization of bond discount by debiting the interest expense account and crediting the bond discount account. 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. 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.

Bonds Issued at a Discount

The effective interest rate is a more accurate figure of actual interest earned on an investment or the interest paid on a loan. We need to pay interest at the end of each year during the period of the bonds. Multiply the $100,000 by the 5% interest rate and $5,000 is the amount of interest you owe for year 1. Subtract the interest from the payment of $23,097.48 to find $18,097.48 is applied toward the principal ($100,000), leaving $81,902.52 as the ending balance. In year 2, $81,902.52 is charged 5% interest ($4,095.13), but the rest of the 23,097.48 payment goes toward the loan balance.

Amortizing the Bonds Discount or Premium FAQs

This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. An interest-bearing asset also has a higher effective interest rate as more compounding occurs. For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.

Understanding Amortized Bonds

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.