Definition of Amortization of Bond Discount?
Amortization can be defined as a process that is carried out to reduce the cost base of a given bond for each subsequent period in order to reflect the nearing maturity date of the relevant financial statement. The amortization process is done at the face value of the bond.
Amortization of Bond Discount is mainly used to show the actual value of a particular investment, primarily when there is a difference between the coupon rate of the bond and the existing market rate.
Amortization of Bonds can take place via two approaches: The Straight Line Method, and Effective Interest Rate Method. Mostly, organizations prefer opting for Effective Interest Rate Method because it is more relevant and presents a more accurate picture of the bond discounts.
Explanation of Amortization of Bond Discounts
A business normally issues bonds when they require a source of long-term cash funding. When organizations issue bonds, investors hardly ever pay the face value of the bonds issued, in the case where the coupon rate (i.e. stated interest rate) on the bonds is less than the market interest rate. By paying an amount lesser than the face value of the bond, investors earn a greater return on the reduced investment. In this scenario, the issuing party normally issues the bonds at a discounted rate.
The discount amount (equivalent to the difference between face value, and the amount paid) is parked in a contra-liability account, and this amount is then amortized over the term of the bonds. This in return impacts the interest expense of the business discounts.
The net result of this impact is that the total recognized amount of interest expense across the lifespan of the bond tends to be greater than the amount of interest that is actually paid to the investors. The amount subsequently recognized then equates to the market interest rate on the date when the bonds were actually sold.
Accounting Treatment and Journal Entries for Bond Discounts
When a company issues a bond on discount, the following journal entries are required:
| Particular | Debit | Credit |
| Cash Received | xxx | |
| Discount on Bonds Payable | xxx | |
| Bonds Payable | xxx |
In the journal entries above, it can be seen that cash received in lieu of bonds payable is at a lower price as compared to the actual face value of the bond. The difference between both, the actual cash received as well the face value is debited as a discount offered on bonds payable.
In the same manner, when the interest is paid, the following transactions are required:
| Particular | Debit | Credit |
| Interest Expense | xxx | |
| Discount on Bonds Payable | xxx | |
| Bank | xxx |
Straight Line Method and Bond Amortization
Bond Amortization can also be done via the Straight Line Method. In this case, Bond Discount for every period is going to equal the total bond discount divided by the maturity of the bond (or the number of periods when interest has to be paid).
Therefore, the formula for bond amortization under the straight-line method would be as following:
Bond Amortization (Straight Line Method) = Bond Discount / (Number of years to maturity x periodic payments)
Effective Interest Method and Bond Amortization
In accordance with the effective interest method, bond amortization in each period is equal to the difference between the product of the bond carrying value and the market interest rate, as well as the product of bond face value, and the coupon rate.
The formula for bond amortization using the Effective Interest Rate Method is as follows:
Bond Amortization = [Bond Value x (Effective Interest Rate/ periods)] – [Face Value x (Coupon Rate / periods)]
Example of Amortization of Bond Discount – Straight Line Method
Lopez Co. has issued a bond equivalent to $10,000,000, for a time to maturity of 5 years. The coupon rate of the bond is 6%. This rate is lower than the current market rate of the bond discount.
Since the effective interest rate of the market is lower than the coupon rate offered by the bank, Lopez Co. does not receive the full amount equivalent to the face value of the bond. The market interest rate (or the effective interest rate) is set at 6.2%. This implies that the bonds are issued at a discount.
Let’s assume that the actual cash received by Lopez Co. is $9,900,000.
Upon receiving the money from the bonds, Lopez Co. is going to record this transaction in the following manner in the Balance Sheet:
| Particular | Debit | Credit |
| Cash (Amount received from Bonds Issued) | $9,900,000 | |
| Discount on Bonds Issued | $100,000 | |
| Bonds Payable | $10,000,000 |
In the case where the bond issue took place right before the year-end, the bonds payable account, as well as the bonds payable account would be netted together. Therefore, the total amount presented would be equivalent to $9,900,000.
However, it must be noted that Lopez Co. is supposed to reduce the $100,000 discount across the life of the bond instrument, such that the balance in the discount account is zero till the maturity date.
Under the straight-line method of amortization, the following journal entries would be required to record interest expense:
| Particular | Debit | Credit |
| Interest Expense | $20,000 | |
| Discount on Bonds Payable | $20,000 |
Since the maturity is for a duration of 5 years, the same discount is going to be charged across all the years for bond amortization.
Example of Amortization of Bond Discount – Effective Interest Rate Method
Lopez Co. has issued a bond equivalent to $10,000,000, for a time to maturity of 5 years. The coupon rate of the bond is 6%. This rate is lower than the current market rate of the bond discount.
Since the effective interest rate of the market is lower than the coupon rate offered by the bank, Lopez Co. does not receive the full amount equivalent to the face value of the bond. The market interest rate (or the effective interest rate) is set at 6.2%. This implies that the bonds are issued at a discount. The money that is received by Lopez Co. is equivalent to $9,852,591.
Bond Amortization for Lopez Co for the first year is going to be calculated using the following formula:
Bond Amortization = [Bond Value x (Effective Interest Rate/ periods)] – [Face Value x (Coupon Rate / periods)]
Bond Amortization = [(9,900,000 x 6.2%) – (10,000,000 x 6%)]
Bond Amortization = 613,000 – 600,000 = $13000
Upon receiving the money from the bonds, Lopez Co. is going to record this transaction in the following manner in the Balance Sheet:
| Particular | Debit | Credit |
| Cash (Amount received from Bonds Issued) | $9,987,000 | |
| Discount on Bonds Issued | $13000 | |
| Bonds Payable | $10,000,000 |
In the case where the bond issue took place right before the year-end, the bonds payable account, as well as the bonds payable account would be netted together. Therefore, the total amount presented would be equivalent to $9,987,000.
However, it must be noted that Lopez Co. is supposed to reduce the $13,000 discount across the life of the bond instrument, such that the balance in the discount account is zero till the maturity date.
The amortization process of bond discount takes place using the effective interest rate method. Using this method, the amount charged to the interest expense account changes in every period. This means that the discount would reduce over the periods, and eventually converge both, the face value of the bond, as well as the market value.