Under the effective interest rate method, we need to determine the effective interest rate using the cash flow provided by the bonds throughout the periods. In this case, the carrying value of the bonds payable on the balance sheet will equal bonds payable minus the bond discount. On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000). The cash interest payment is the amount of interest the company must pay the bondholder.

This causes the bond to sell at a price lower than the face value of the bond and the difference is attributable to bond discount. Similarly, bond premium occurs when the coupon rate is higher than the market expectation of required return. Due to higher coupon rate, there is high demand for the bond and it sells for a price higher than the face value of the bond. The difference between the face value of the bond and the bond price is called bond premium. The company usually issues the bond at a discount when the market rate of interest is higher than the contractual interest rate of the bond.

Because the principal of the loan is repaid over time, it’s less of a strain on the company than making a balloon payment. In addition, amortization reduces the duration of the bond, which helps companies better control the interest expense. In many ways, bond amortization is beneficial to investors and the companies issuing the bond. Unamortized bond discount is a contra account to bonds payable which its normal balance is on the debit side. Likewise, the balance in this unamortized bond discount will be presented as a deduction from the bonds payable on the balance sheet.

Bonds Issued at a Discount

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 increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. The amortization process of bond discount takes place using the effective interest rate method.

  • This journal entry will reduce the interest expense on the income statement that we record at the time of interest payment.
  • For example, when an expense not in cash is previously used in the calculation of net income, the expenditure amount not made in cash is added again to fix the cash flow.
  • Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes.

The effective interest rate method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative simpler method is the straight line method. A common factor between bond amortization and indirect cash flow method is that both of them involve interest expenses which are not in cash. In the indirect cash flow method, the expenses not in cash are adjusted to the net income (which is a profit in accounting that has expenses in cash and also not in cash). The change to the net income is either an addition or subtraction depending on the bond redemption type.

The premium will decrease bond interest expense when we record the semiannual interest payment. On a period-by-period basis, accountants regard the effective interest method as far more accurate for calculating the impact of an investment achieve outcomes on a company’s bottom line. To obtain this increased accuracy, however, the interest rate must be recalculated every month of the accounting period; these extra calculations are a disadvantage of the effective interest rate.

What Is the Effective Interest Method of Amortization?

Interest expenses are non-operating costs and are crucial in helping a business to cut down on its earnings before tax (EBT) expenses. With the straight-line method, you are debiting more interest revenue each year until there is no remaining bond discount or premium. The effective interest method will allow you to record more interest revenue in early years and less interest revenue in later years. Accountants can use either the straight-line method or the effective interest method to amortize the bond discount or premium. The bond amortization schedule calculator is one type of tvm calculator used in time value of money calculations, discover another at the links below.

How do you determine how much of a premium or discount to amortize each period?

The journal entry to amortize contains a debit to the income statement account Bond Interest Expense and a credit to the balance sheet account Discount on Bonds Payable. This is because the carrying value of bonds payable equal bonds payable minus bonds discount or the bonds payable plus bond premium. Hence, once the balance of bond discount or bond premium becomes zero, the carrying value of the bonds payable will equal the balance of bonds payable itself which is the face value of the bonds. In other words, we amortize the bond discount or bond premium to eliminate the discount or premium amount of the issued bond by transferring it to the interest expense account.

Amortizing Bond Discount with the Effective Interest Rate Method

Therefore, the amortization causes interest expense in each accounting period to be higher than the amount of interest paid during each year of the bond’s life. And the amortization of bond discount will increase the carrying value of the bonds payable on the balance sheet from one period to another until it equals the face value of the bond at the end of the bond maturity. After all, at the end of the bond maturity, the balance of the unamortized bond discount will become zero. Discounted bonds’ amortization always leads to an effective interest expense that is higher than the payment of the bond interest coupon for each period. If a bond is sold at a discount, it means that the market interest rate is above the coupon rate. In this case, the amortization amount of the bonds’ discount for each period in the payment of the cash coupon is added to get the expense by real interest for net income calculation.

Using this example, one can see that a discount bond has a positive accrual; in other words, the basis accretes, increasing over time from $0.19, $0.20, and so on. Periods 3 to 10 can be calculated in a similar manner, using the former period’s accrual to calculate the current period’s basis. Likewise, at the end of the maturity of the bond, the $12,000 of the bond premium will become zero. In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation. In this entry, Cash is debited for $600, which is the full 6 months’ interest payment ($12,000 x 0.05).

Treasury bond, although the same principles apply to corporate bond trades. When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interest rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value. 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%.

This leads to the subtraction of the bonus amortization amount for each period of the coupon payment in cash to realize the real expense and calculate the net income. For cash flow calculation, the cash coupon payment that is not a financial expense in the bonus amortization premium is subtracted from the net income as cash outflow. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is reduced to 250,000, and the premium on bonds payable (9,075) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash. When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account.

The bond amortization calculator calculates the total premium or discount over the term of the bond. The straight line method amortization for each period, and produces an effective interest method amortization schedule showing the premium or discount to be amortized each period. 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.