Amortizable Bond Premium Definition

Also, the yield to maturity is stated in annual terms, so semi-annually the yield to maturity is 1.945% (3.89% / 2). When market interest rates decrease, for any given bond, the fixed coupon rate is higher relative to other bonds in the market. It makes the bond more attractive, and it is why the bond is priced at a premium. When market interest rates rise, for any given bond, the fixed coupon rate is lower relative to other bonds in the market.

The amount of the discount or premium to be amortized is the difference between the interest figured by using the effective rate and that obtained by using the face rate. For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. The net effect of creating the $40,000 premium and writing off $10,000 of it gives the company an interest expense of $40,000 instead of $50,000, since the $50,000 expense is reduced by the $10,000 premium write down at the end of the year.

Journal Entry Format

The adjusted acquisition price of the bond on August 1, 1999, is $109,354.71 (the adjusted acquisition price at the beginning of the period ($110,000) less the bond premium allocable to the period ($645.29)). Understanding how bond premiums and discounts will be calculated and recognized on the financial statements will be critical to your understanding of this topic. Think of bonds as financial securities that are separate from its respective premium or discount amount.

Over time, the carrying amount of the bonds is slowly reduced to $100,000 due to the amortization of the premium each year. Each year, we add the amortization to the carrying value and repeat these steps to find the next year’s interest expense and discount amortization. Under the effective interest method, a company’s interest expense and amortization amount will change every single year. 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.

What Are the Difference Between Annual Straight Line Amortization vs. Effective Interest Amortization?

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.

In order to calculate the premium amortization, you must determine the yield to maturity (YTM) of a bond. The yield to maturity is the discount rate that equates the present value of all coupons and principal payments to be made on the bond to its initial purchase price. The Premium must be amortized or written off by the company in its books of accounts over the bond’s life systematically. The amortization of bond premium refers to charging the Premium as a finance cost over the bond’s life. Notice that under both methods of amortization, the book value at the time the bonds were issued ($104,100) moves toward the bond’s maturity value of $100,000. The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.

Straight-Line Method of Amortization

The initial journal entry to record the issuance of the bonds, and the final journal entry to record repayment at maturity would be identical to those demonstrated for the straight-line method. However, each journal entry to record the periodic interest expense recognition would vary and can be determined by reference to the preceding amortization table. It helps the issuer write off the same interest expense over the bond’s life and claim tax benefits. For the investor, the bond premium forms part of the cost of the bond.

For example, for a bond with a face value of $1,000 paying a 5% coupon rate, the coupon per year will be $50. The table below shows how this example bond would be accounted for over the full 10-year period. Note that the only static figure is the amount of cash interest — interest expense and amortization are different in every single year.

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It makes the bond more unattractive, and it is why the bond is priced at a discount. Suppose the company issues 2000 bonds for $ 22,800 each, and the face value of the bonds is $ 20,000. The bonds are to be redeemed after a period of 10 years at face value. The coupon rate of bonds is 10%, and the market law firm bookkeeping rate of interest stands at 8%. The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value.

This offset occurs when the holder takes the qualified stated interest into account under the holder’s regular method of accounting. These calculations are applied individually to each maturity within a series when using the Effective Interest Rate method. See below for our total premium/discount amortization schedule for our Series 2022 issue. 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.