What is the Amortization of Bond Premium?Amortization of Bond Premium refers to the amortization of excess premium paid over and above the face value of the Bond. A bond has a stated coupon rate of interest and pays interest to the bond investors based on such a coupon rate of interest. It is valued at the present value of interest payments and face value determined based on the market interest rate. The investors pay more than the face value of the bonds when the stated interest rate (also called coupon rateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more) exceeds the market interest rate.
Methods of Amortization of Bond Premium CalculationPremium Bond Amortization can be calculated based on two methods, namely,
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with an attribution linkArticle Link to be Hyperlinked #1 – Straight Line MethodUnder the straight-line method, the bond premium is amortized equally in each period. It reduces the premium amount equally over the life of the bond. The formula for calculating the periodic amortization under the straight-line method is: Bond Premium Amortized = Bond Premium / No. of Years Example of Premium Bond AmortizationLet us consider if 1000 bonds are issued for $ 22,916, having a face value of $20,000. The Bond Premium will be Bond Premium = $2916000 Bond Premium Amortized calculation can be done using the above formula as, =($22,916 – $ 20,000) X 1000 Bond Premium Amortized will be – Bond Premium Amortized =$ 291,600 Therefore, the Bond Premium amortized will be $ 2,916,000/10 = $ 291,600 #2 – Effective Interest Rate MethodUnder the Effective Interest Rate Method, amortization is done by reducing the balance in the premium on bonds payableBonds payable are the company's long-term debt with the promise to pay the interest due and principal at the specified time as decided between the parties. A bond payable account is credited in the books of accounts with the corresponding debit to the cash account on the issue date.read more the difference between two terms or periods. Under this method, the bond premium to be amortized periodically is calculated by using the following formula: Bond Premium Amortized= P x R – N x Y Where,
Example of Premium Bond AmortizationLet us consider an investor that purchased a bond for $20,500. The bond’s maturity period is 10 years, and the face value is $20,000. The coupon rate of interest is 10% and has a market rate of interest at 8%. Let us calculate the amortization for the first, second, and third period based on the figures given above: For the remaining 7 periods, we can use the same structure presented above to calculate the amortizable bond premium. It can be seen from the above example that a bond purchased at a premium has a negative accrual, or in other words, the basis of the bond amortizes. The accounting treatment for Interest paid and bond premium amortized will remain the same, irrespective of the method used for amortization. The journal entry for interest payment and bond premium amortized will be: Advantages and LimitationsThe primary advantage of premium bond amortization is that it is a tax deduction in the current tax year. Suppose the interest paid on the bond is taxable. In that case, the premium paid on the bond can be amortized, or in other words, a part of the premium can be utilized towards reducing the amount of taxable income. Also, it leads to reducing the cost basis of the taxable bond for premium amortized in each period. However, in the case of tax-exempt bonds, the amortized premium is not deductible while determining the taxable incomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more. But the bond premium has to be amortized for each period, and a reduction of cost basis in the bond is necessary each year. ConclusionFor a Bond investor, the premium paid for a bond represents part of the cost basis for tax purposes. Therefore, premium amortized yearly can be used to adjust or reduce tax liability created by interest incomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more generated from such bonds. Calculating Bond Premium amortized can be done by any of the two methods mentioned above, depending on the type of bond. Both bond amortization methods give the same final results. However, the difference arises in the pace of interest expenses. The Straight Line method of amortizationStraight-line amortization amortizes the cost of intangible assets or allocates the interest expenses associated with the bond's issue in each accounting period until the end of the intangible asset or maturity of bond respectively in the income statement.read more gives the same interest expenses in each period. An effective Interest rate method of amortization, on the other hand, gives decreasing interest expenses over time for premium bondsA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value. This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest. For instance, a bond with a face value (par value) of $750, trading at $780, will reflect that the bond is trading at a premium of $30 ($780-750). read more. In simple words, expenses decrease with a decrease in book value under the Effective Interest rate method. This logic seems practical, but the straight-line method is easier to calculate. If the primary consideration is to defer current income, the Effective Interest rate method should be chosen to amortize the premium on bonds. The Straight Method is preferable when the premium amount is very less or insignificant. Recommended ArticlesThis article has been a guide to Premium Bond Amortization is and its definition. Here we discuss the top 2 methods to calculate amortization of bond premium along with practical examples, advantages, and limitations. You may learn more about accounting from the following articles –
How do you calculate amortization of a discount bond?Divide the total discount or premium by the number of remaining periods in order to determine the amount to amortize in the current period. Multiply the face value of the bond by its stated interest rate to arrive at the interest payment to be made on the bond in the period.
Is bond amortization an expense?In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company's interest expense on its income statement. The interest expense, a non-operating cost, reduces a company's earnings before tax (EBT) and, therefore, the amount of its tax burden.
How should the amortization of bond discount on long term debt be reported in a statement of cash flows prepared using the indirect method?When preparing the statement of cash flows using the indirect method, the amortization of a bond discount should be eliminated by adding the amount back to net income in the operating section.
How should discount on bonds payable be reported on the financial statements?Discount on Bonds Payable will always appear on the balance sheet with the account Bonds Payable. In other words, if the bond is a long-term liability, both Bonds Payable and Discount on Bonds Payable will be reported on the balance sheet as long-term liabilities.
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