Content
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. A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. Our mission is to empower readers with the most factual and reliable financial law firm bookkeeping information possible to help them make informed decisions for their individual needs. Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible.
Effective Interest Rate Method vs Straight-Line Method
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. This discount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The discount will increase bond interest expense when we record the semiannual interest payment. Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, such as the 30-year U.S. Treasury bond, although the same principles apply to corporate bond trades.
- As you can see, according to the straight-line method the amortization of premium is the same for all periods.
- Each year, the company will have to pay $8,000 in cash interest (coupon rate of 8% X $100,000 in face value).
- A deduction determined under this paragraph (a)(4)(i)(A) is not subject to section 67 (the 2-percent floor on miscellaneous itemized deductions).
- The preferred method for amortizing (or gradually expensing the discount on) a bond is the effective interest rate method.
- When market interest rates decrease, for any given bond, the fixed coupon rate is higher relative to other bonds in the market.
- The Premium must be amortized or written off by the company in its books of accounts over the bond’s life systematically.
The company typically chooses to issue the bond when it has exhausted most or all of its current sources of financing, but still needs additional funds in the short run. By the time the bonds reach maturity, their carrying value will have been reduced to their face value of $100,000. Since bonds are an attractive investment, the price was bidded up to $107,722, and the premium of $7,722 is considered a reduction of interest expense. The premium of $7,722 represents the present value of the $1,000 difference that the bondholders will receive in each of the next 10 interest periods. See § 1.446–2(b) to determine the accrual period to which qualified stated interest is allocable and to determine the accrual of qualified stated interest within an accrual period.
Issuance of Bond at Premium
Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date.
The calculations are similar to those used in the discount example in Accounting for Bonds Issued at a Discount. Dive into how we made our CPA review course a better tool than the outdated methods you’re used to seeing. DebtBook’s Effective Interest Rate methodology reflects this “interest method” as referenced in GASB 62. Collaborate easily in the cloud with internal teams and external partners. Stay up to date with the latest releases in debt and lease management. Experience debt and lease data you can really trust to keep your clients safe.
The Rationale Behind the Effective Interest Rate
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). The only difference is that the interest expense will be lower than the coupon payment by the amount of amortization. The straight line method is just like the straight line method for depreciation. The total premium/discount is divided equally over the life of the bond and these equal amounts are amortized every year. There are two methods for amortizing the premium or discount of bonds.
Although the borrower receives all of the funds at the time of the issue, the matching convention requires that it be recognized over the life of the bond. (2) The amount of any payment previously made on the bond other than a payment of qualified stated interest. An interest-bearing asset also has a higher effective interest rate as more compounding occurs.
DebtBook’s new Premium/Discount Amortization feature gives clients the ability to track their amortization of original issuance premium/discount (“OIP” or “OID”) within their DebtBook profile. If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%. While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate.
