A business or government may issue bonds when it needs a long-term source of cash funding. When an organization issues bonds, investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate. The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors. The amount recognized equates to the market rate of interest on the date when the bonds were sold. Notice that the effect of this journal is to post the interest of 4,249 to the interest expense account. Assume that a corporation prepares to issue bonds having a maturity value of $10,000,000 and a stated interest rate of 6%.
Calculating interest expense on a payable bond should be relatively straightforward, but then the accountants got involved. Generally accepted accounting principles, or GAAP, turn what is ordinarily a simple multiplication problem into something slightly more complicated. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month. Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them. This entry records $5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
Recordkeeping for Discount Amortizations
Since these bonds will be paying investors more than the interest required by the market ($300,000 semiannually instead of $295,000 semiannually), the investors will pay more than $10,000,000 for the bonds. From the straight line bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 120,000, and the discount on bonds payable (2,152) has been amortized to interest expense. As before, the final bond accounting journal would be to repay the face value how to calculate premium on bonds payable of the bond with cash. If the company issues only annual financial statements and its accounting year ends on December 31, the amortization of the bond discount can be recorded on the interest payment dates by using the amounts from the schedule above. In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31. The entries for 2022, including the entry to record the bond issuance, are shown next.
- The entry to record the issuance of the bonds increases (debits) cash for the $9,377 received, increases (debits) discount on bonds payable for $623, and increases (credits) bonds payable for the $10,000 maturity amount.
- Rather than changing the bond’s stated interest rate to 8%, the corporation proceeds to issue the 9% bond on January 1, 2022.
- For tax purposes, you can reduce your $60 in taxable interest by this $6 for a net of $54.
- If a bond is issued at a given rate and then prevailing interest rates in the bond market fall, then the higher-interest bond looks better than it did previously.
- The straight line bond amortization method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative more acceptable method is the effective interest rate method.
Let’s assume Company ABC issues a 5-year, $100,000 bond with a stated interest rate of 5% and a market interest rate of 4%. Bond prices move up and down constantly, and it’s common for bond investors to face situations where they have to pay more than the face value of a high-interest bond in order to persuade the current owner to sell it. If you pay a premium to a bond’s face value, you can amortize that premium over the remaining term of the bond. Doing so requires that you keep track of the unamortized bond premium so that you can make the appropriate calculations for annual amortization. Below, we’ll take a closer look at buying bonds at a premium and handling them correctly for tax purposes. The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method.
What is the Amortization of Premium on Bonds Payable?
When the bond matures, the discount will be zero and the bond’s carrying value will be the same as its principal amount. The discount amortized for the last payment may be slightly different based on rounding. See Table 1 for interest expense calculated using the straight‐line method of amortization and carrying value calculations over the life of the bond.
- Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different.
- The discount will increase bond interest expense when we record the semiannual interest payment.
- Below, we’ll take a closer look at buying bonds at a premium and handling them correctly for tax purposes.
- The bondholders are reimbursed for this accrued interest when they receive their first six months’ interest check.
- The issuer increases the price of the bond to investors and in turn decreases their interest rate earned on their investment.
- From the straight line bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 120,000, and the discount on bonds payable (2,152) has been amortized to interest expense.
- This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12).