Bond accounting principles

2. Periodic amortization of the bond discount or premium

For bonds issued at face value, interest payment entries are simple: debit Interest Expense and credit Cash. Discounts and premiums, on the other hand, add a layer of complexity to interest payments. A discount represents additional interest expense that must be amortized over the life of the loan, while a premium represents a reduction in interest expense that also needs to be amortized. There are two methods we can use to spread out the discount or premium over the life of the bond.

The straight-line method divides the discount or premium evenly among all interest payments. In our example of the bond issued at a discount, $7,056 ($70,560 divided by ten payments) is added to the $60,000 payment to arrive at interest expense for the period. For the premium bond, the $60,000 payment is reduced by $8,032 ($80,320 divided by ten payments) to derive interest expense.

The effective interest rate method is somewhat more complicated. Total interest expense is first found by multiplying the market rate by the previous book (carrying) value of the bond, which is face value plus any unamortized premium or less any unamortized discount. The interest expense calculated is then split between the periodic interest payment and the discount or premium. Below is the accounting entry made for periodic interest payments - we’ll stick with the face value bond and the discounted bond under both possible methods.

Account Names

Debits

Credits

Face Value

   

Interest Expense

60,000

 

     Cash

 

60,000

     

Discount, Straight-Line Method

   

Interest Expense

67,056

 

     Discount on Bond Payable*

 

7,056

     Cash

 

60,000

     

Discount, Effective Interest Rate Method

   

Interest Expense**

65,061

 

     Discount on Bond Payable

 

5,061

     Cash

 

60,000

(*) $7,056 = $70,560 ÷ 10

(**) $65,061 = $929,440 x 7%, rounded

Eventually, the bond’s book value equals its face value after the last interest payment under both methods - this can be shown using an amortization schedule projected out over the life of the loan. If the difference in interest expense between the two methods is material, US GAAP requires the effective interest method because it better matches interest expense with the carrying amount of the loan. Otherwise, either method may be chosen. Note that if interest payments are made on a semiannual basis, the interest rates used above would be cut in half for each payment.

You should be aware that corporations sometimes buy their own bonds on the open market. The accounting entry for early debt retirement is complex and is beyond the scope of this article.

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