Bond Premium Amortization Schedule Example

In lending, the effective annual interest rate might refer to an interest calculation wherein compounding occurs more than once a year. In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price. In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year.

• If this bond then sold for $1,200, its effective interest rate would sink to 5%.
• Under § 1.171–1, the amount of bond premium is $10,000 ($110,000−$100,000).
• 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.
• Once the bond premium is calculated, you need to decide how the bond premium shall be amortized.
• To find interest and the amortization of discounts or premiums, the effective interest rate is applied to the carrying value of the bonds (face value minus the discount or plus the premium) at the beginning of the interest period.
• Today, let’s discuss the methods of amortizing bond discount or premium.

The technique through which such write-off is done is known as amortization. To calculate interest expense for the first period, we multiply the carrying value of the bonds ($106,710.08) by investors’ required return (8%) to get interest expense of $8,536.81. Today, let’s discuss the methods of amortizing bond discount or premium. The table below presents an amortization schedule for this bond issue using the straight-line method. Thus, the total interest expense for each period is $5,228, which consists of the $6,000 cash interest less the premium amortization of $772. The premium of $7,722 is amortized using either the straight-line method or the effective interest method.

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The effective interest rate is a more accurate figure of actual interest earned on an investment or the interest paid on a loan. For example, effective interest rates are an important component of the effective interest method. Thus, the bond premium to be amortized yearly under this method comes to $560,000. To calculate premium amortization, we take the amount of cash interest ($9,000) and subtract the interest expense ($8,536.81) to get premium amortization of $463.19. The bond is issued at a premium in order to create an immediate capital gain for the issuer.

A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year. The effective interest method is used when evaluating the interest generated by a bond because it considers the impact of the bond purchase price rather than accounting only for par value. The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis. There are several significant differences between the effective rate method and the straight-line method.

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To calculate total interest expense for the first year, we take the carrying amount of the bond and multiply it by investors’ required return of 10%. For example, consider a company that issues 10% bonds with a face value of $100,000 for $95,000. However, the difference between how much it has to ultimately repay in principal ($100,000) and the amount it received from selling the bonds ($95,000) represents an additional cost of financing. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan.

• Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method.
• In this case, however, the bonds are issued when the prevailing market interest rate for such investments is 10%.
• Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.
• Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes.
• First, the effective rate method is more difficult to calculate, and so is more likely to be avoided when the discount or premium amount is small.
• In effect, the premium should be thought of as a reduction in interest expense that should be amortized over the life of the bond.
• In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding.

Therefore, the bond premium allocable to the accrual period is $1,118.17 ($10,000−$8,881.83). 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. 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.

What is the Amortization of Premium on Bonds Payable?

Assume that the final payment will be $2,774.99 in order to eliminate the potential rounding error of $1.06. In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. She will repay the loan with five equal payments at the end of the year for the next five years. Another way to calculate the $5,228 is to divide the total interest cost of $52,278, as just calculated, into the 10 interest periods of the bond’s life.

When bonds are sold at a discount or a premium, the interest rate is adjusted from the face rate to an effective rate that is close to the market rate when the bonds were issued. Therefore, bond discounts or premiums have the effect of increasing law firm bookkeeping or decreasing the interest expense on the bonds over their life. Under these conditions,it is necessary to amortize the discount or premium over the life of the bonds by using either the straight-line method or the effective interest method.

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A fully amortized loan is fully paid by the end of the maturity period. The premium should be thought of as a reduction in interest expense that should be amortized over the life of the bond. The bonds were issued at a premium because the stated interest rate exceeded the prevailing market rate. The Effective Interest Rate to Maturity method calculates a premium/discount amortization for each maturity on a stand-alone basis, then combines these values to generate a total amortization schedule for the issue in whole. Treasury or a corporation sells, a bond instrument for a price that is different from the bond’s face amount, the actual interest rate earned is different from the bond’s stated interest rate. The bond may be trading at a premium or at a discount to its face value.