The bond traders are required to use the new amortized cost in case a bond in negotiated before its maturity. A premium or discount bonus sold above the amortized is subjected to tax no matter the original cost. Bonds that are sold below the amortized costs incur losses, and because of this, an essential concept of the exchange of taxes is utilized to avoid capital gains of the bonds. Exchange of taxes means that there are commercial ties with the losses of the same type of bonds to ensure the recognition of tax loss for purposes of income tax. Likewise, the bond discount in this journal entry is the difference between the cash we receive and the face value of the bond we issue. And the normal balance of the bond discount is on the debit side as it is a contra account to the bonds payable.
According to the Internal Revenue Service, premium amortization in the fiscal accounts does not result in the capital loss for the client. With the discount vouchers, the cost base of a US savings bond is raised and is also a taxable capital gain. Investors who purchase only the bonds sold at par are those who avoid the inconvenience of reporting the changes for each bond. Other tax effects The price of bonuses varies each day, and the amortization is based on the reality the bonds must be exchanged in at maturity.
- Consequently, zero-coupon bonds are taxed as interest, just like any other original issue discount bond.
- The bond’s principal is divided up according to the security’s amortization schedule and paid off incrementally (often in one-month increments).
- The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026.
- For each period, the interest expense in Column 2 is the semiannual yield rate at the time of issue, 5%, multiplied by the carrying value of the bonds at the beginning of the period.
- The bond’s carrying value at the end of the period in Column 6 is reduced by the premium amortization for the period.
By paying an amount lesser than the face value of the bond, investors earn a greater return on the reduced investment. In this scenario, the issuing party normally issues the bonds at a discounted rate. In accounting, we may issue a bond at a discount or at a premium which results in the carrying value of the bonds payable recorded on the balance sheet being lower or higher than the face value of the bond.
Understanding the Effective Interest Rate Method
Municipal bonds pay a commensurately lower rate than other bonds as a result of their tax-free status. In this case, we can make the journal entry for the amortization of bond premium by debiting the bond premium account and crediting the interest expense account. The table starts with the book value of the bond which is the face value (250,000) less the discount on bonds payable (8,663), which equals the amount of cash received from the bond issue (241,337).
Interest expenses, which are non-operating costs, help businesses reduce earnings before tax (EBT) expenses. 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. In the case where the bond issue took place right before the year-end, the bonds payable account, as well as the bonds payable account would be netted together. In this case, Bond Discount for every period is going to equal the total bond discount divided by the maturity of the bond (or the number of periods when interest has to be paid). The discount amount (equivalent to the difference between face value, and the amount paid) is parked in a contra-liability account, and this amount is then amortized over the term of the bonds. For example, the company ABC issued $300,000 bonds at a discount for only $285,000 which is 95% of their face value.
What Is the Effective Interest Method of Amortization?
Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable. Effective-interest method requires a financial calculator or spreadsheet software to derive. In this case, the investor pays more than the face value of a bond when the stated interest rate is greater than the market interest rate.
What Is Accretion of Discount?
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 bookkeeping 2020 the discount or premium amount of the issued bond by transferring it to the interest expense account. The systematic allocation of the discount on bonds payable (reported as a debit in a contra-liability account) to Bond Interest Expense over the life of the bonds.
Example of Amortization of Bond Discount – Effective Interest Rate Method
The amortization process of bond discount takes place using the effective interest rate method. Using this method, the amount charged to the interest expense account changes in every period. This means that the discount would reduce over the periods, and eventually converge both, the face value of the bond, as well as the market value. The amortization of bond discount can be done with the straight-line method or the effective interest rate method depending on if the amount of discount is material or not.
When we issue a bond at a discount, remember we are selling the bond for less than it is worth or less than we are required to pay back. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. 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.
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Likewise, the carrying value of the bonds payable equals the balance of bonds payable less the balance of the unamortized bond discount. 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. As discussed, when a bond is issued at a discount, a prorated portion of the discount is reported as income by the taxpayer, every year until maturity. When bonds are purchased at a premium (greater than $1,000 per bond), a prorated portion of the amount over par can be deducted annually on the purchaser’s tax return.
If the discounted amount is material the company need to amortize the bond discount with the effective interest rate method as it is a more accurate method compared to the straight-line method. Under the matching principle of accounting, the bond discount should be amortized over the life of the bond; hence, the term “unamortized bond discount” is used here. Likewise, with the amortization, the balance of the unamortized bond discount will be reduced throughout the life of the bond until it becomes zero at the end of bond maturity. 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. After all, investors are unlikely to pay for the bonds at the face value if they can invest in other securities with similar risks but providing a better rate of return. Municipal bonds are often favored by high-income investors looking to reduce their taxable investment income.
Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.