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. Conversely, the effective interest method results in more amortization in later years than the straight line method. When the bond matures, however, there should be no difference at all in the total amount of cash interest, interest expense, or amortization between the two methods for the same bond. Suppose the company issued $100,000 of 10-year bonds that pay an 8% annual coupon.
The payment amount is calculated with the PMT(rate, nper, pv,, ) function. The bondholders receive $6,000 ($100,000 x .06) every 6 months when comparable investments were yielding only 10% and paying $5,000 ($100,000 x .05) every 6 months. In effect, the premium should be thought of as a reduction in interest expense that should be amortized over the life of the bond. This entry records $1,000 interest expense on the $100,000 of bonds that were outstanding for one month.
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Under § 1.171–1, the amount of bond premium is $20,000 ($120,000—$100,000). The qualified stated interest allocable to the first taxable year is $9,166.67 ($10,000 ×
11/12). The bond premium allocable to the first taxable year is $1,024.99 ($1,118.17 ×
We will illustrate the problem by the following example related to a premium bond. 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. The relevant T accounts, along with a partial balance sheet as of 1 July 2020, are presented below.
The Difference Between the Effective Rate Method and the Straight-Line Method
An overview of these methods, using discount and premium examples, is given below. The table below shows how to determine the price of Valenzuela Corporation’s 5-year, 12% bonds issued to yield. To illustrate, consider the following balance sheet from Valenzuela Corporation prepared on 2 January 2020 immediately after the bonds were issued. Suppose that on 2 January 2020, Valenzuela Corporation issued $100,000, 5-year, 12% term bonds. Under the straight-line method, bond premium is amortized equally in each period. Companies do not always issue bonds on the date they start to bear interest.
Interest expense is a constant percentage of the bond’s carrying value, rather than an equal dollar amount each year. The theoretical merit rests on the fact that the interest calculation aligns with the basis on which the bond was priced. Bonds that result in a premium or a discount should be amortized by either applying the effective interest method or the straight-line method. For your exam, it is very important that you understand how to calculate the periodic amortization expense that will be applied to the premium or the discount. Par value, in turn, is simply another term for the bond’s face value, or the stated value of the bond at the time of issuance.
The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then the interest earned will decline also. The preferred method law firm bookkeeping for amortizing (or gradually expensing the discount on) a bond is the effective interest rate method. Under this method, the amount of interest expense in a given accounting period correlates with the book value of a bond at the beginning of the accounting period.