How to Amortize a Bond Premium Using the Straight-Line Method The Motley Fool

For example, if a bond with a face value of $10,000 is purchased for $9,500 and the interest payment is $500, then the effective interest rate earned is not 5% but 5.26% ($500 divided by $9,500). Treasury or a corporation sells a bond instrument for a price that is different from the bond’s face amount, the actual interest rate earned is different from the bond’s stated interest rate. The bond may be trading at a premium or at a discount to its face value. As with the discount example, the total interest expense over its lifetime under the straight-line and the effective interest methods is the same. This schedule is set up in the same manner as the discount amortization schedule in the above exhibit, except that the premium amortization reduces the cash interest expense every period.

Step 2 of 3

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 liability account called Premium on Bonds Payable. Just like with a discount, the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual interest payment. One big caveat about the straight-line method As simple as the straight-line method is, the main problem with it is that the IRS generally doesn’t allow you to use it anymore. As IRS Publication 550 states, for bonds issued after Sept. 27, 1985, taxpayers must amortize bond premium using the constant-yield method, which differs from the straight-line method.

Comparison of Amortization Methods

This reduces the premium on bonds payable and the interest expense by the amortized amount. In this case, the company can make a lump sum payment rather than several smaller payments. This leads to saving in interest costs and also helps in making a smooth transition from one accounting period to another. Further, companies can pick up the coupon payments in advance and reduce their interest costs. Even though these bonds don’t pay coupons, the Internal Revenue Service (IRS) requires that zero-coupon bondholders still report the imputed interest earned on the bond as income for tax purposes.

Relationship Between Bond Price and Interest Rates

As a result, the amortization schedule accelerates to match the shortened life of the bond, affecting the bond’s carrying value and the effective interest rate. The interest expense recognized will be higher over the shorter period. The decision to use either the constant yield method or ratable accrual method must be made at the time the bond is purchased. This decision is irreversible and is similar to the method the IRS prescribes to computer-taxable original issue discount (OID) as outlined in IRS Publication 1212. Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, retained earnings such as the 30-year U.S. Treasury bond, although the same principles apply to corporate bond trades.

• This premium represents an additional cost to the investor but provides a higher yield compared to bonds purchased at face value.
• The updated bond cost basis is calculated by subtracting the annual bond premium amortization from the initial cost basis.
• Proper recordkeeping and understanding the reporting requirements are essential to ensure compliance with tax laws.
• Let’s walk through what each of these terms mean and how they are calculated using our “Series” information pictured below.
• But then we also had plus the premium of 4,000 gave us a net increase of 54,000 to the liabilities there for this bond payable.

The Internal Revenue Service (IRS) allows investors to deduct the annual amortization of bond premiums premium amortization formula from their taxable income, effectively reducing the amount of taxable interest income. Proper reporting of bond interest income and bond premium amortization is required on annual tax returns. To calculate the amortizable bond premium using the straight-line method, divide the total bond premium by the number of years until maturity.