Understanding these common pitfalls is crucial for maintaining the integrity of financial statements and ensuring that the reported figures convey the true economic reality of the bond investments. Calculate the bond’s issue price by discounting the bond’s future cash flows (interest and principal payments) back to present value using the effective interest rate. When it comes to accounting for bond investments, the method used to amortize the premium or discount can significantly impact the reported interest income and carrying value of the bond. The Effective Interest Method and the Straight-Line Method are two primary approaches used in this process, each with its own set of principles and implications for financial reporting.

Concept 56: Effective Interest Rate Method and Amortization of Bond Discounts/Premiums

In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation. An identical process is followed if the bonds are issued at a discount as the following example shows. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited.

• For investors, they offer a predictable income stream and, depending on the bond’s rating, a relatively low-risk investment option.
• Bonds that do not have specific collateral and instead rely on the corporation’s general financial position are referred to as unsecured bonds or debentures.
• Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping.
• Understanding these nuances is key to making informed decisions in the bond market.
• It allows for a more informed decision-making process, taking into consideration the time value of money and the actual return on investment over the bond’s life.

Bond Amortization Schedule – Effective Interest Method

Assume that Discount Corp. issues 100, five-year, semi-annual, $1,000 bonds with an 8% coupon during a period of time when the market rate is 10% and so receives $92,278 because the coupon rate is lower than the market rate. When a consumer borrows money, she can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When retained earnings balance sheet she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan.

Impact of Market Rates on Bond Carrying Value

When the bond matures at the end of the 10th six-month period, the corporation must make the $100,000 principal payment to its bondholders. The when the effective interest rate method is used, the amortization of the bond premium market value of an existing bond will fluctuate with changes in the market interest rates and with changes in the financial condition of the corporation that issued the bond. For example, an existing bond that promises to pay 9% interest for the next 20 years will become less valuable if market interest rates rise to 10%. Likewise, a 9% bond will become more valuable if market interest rates decrease to 8%.

Discount on Bonds Payable with Straight-Line Amortization

Some bonds require the issuing corporation to deposit money into an account that is restricted for the payment of the bonds’ maturity amount. The restricted account is Bond Sinking Fund and it is reported in the long-term investment section of the balance sheet. It is reasonable that a bond promising to pay 9% interest will sell for less than its face value when the market is expecting to earn 10% interest.

The interest on carrying value is still the market rate times the carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of discount amount is added to the carrying value. Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (14,880) to the interest expense account. Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (10,363) to the interest expense account. Car Dealership Accounting In effect, because the bonds were issued at a premium and the business received more cash than the par value of the bonds, the cost (interest) to the business is reduced each period by the amount of the premium amortized.

First, let’s assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000. An existing bond’s market value will decrease when the market interest rates increase.The reason is that an existing bond’s fixed interest payments are smaller than the interest payments now demanded by the market. Throughout our explanation of bonds payable we will use the term stated interest rate or stated rate. Usually a bond’s stated interest rate is fixed or locked-in for the life of the bond. When a bond fluctuates in price from its par value, it impacts the actual interest rate paid by the bond, known as the effective interest rate.