The IRS requires that the constant yield method be used to amortize a bond premium every year. Suppose the company issues 2000 bonds for $ 22,800 each, and the face value of the bonds is $ 20,000. The bonds are to be redeemed after a period of 10 years at face value. The coupon rate of bonds is 10%, and the market rate of interest stands at 8%.
The amount of amortization is the difference between the cash paid for interest and the calculated amount of bond interest expense. Bond Premiums – Bonds that are issued at a price that is greater than its par value will be considered bonds issued at a premium. Additionally, bonds that are issued at a premium will be those with a market rate that is less than the bonds stated rate. Bond Discounts – Bonds that are issued at a price that is less than its par value will be considered bonds issued at a discount.
When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interest rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value. On December 31, 2018, Edmond, Inc., issued $750,000 of 11 percent, five-year bonds for $722,400, yielding an effective interest rate of 12 percent. When a bond is issued, the book value of the bond is the fair value of the bond based on the market interest rate. Depending on where market interest rates stand vis-à-vis bond’s coupon rate, the bond’s carrying value is at premium, par, or discount.
For purposes of § 1.1016–5(b), the holder’s basis in the bond is reduced by the amount of bond premium allowed as a deduction under this paragraph (a)(4)(i)(C)(1). As is to be expected, the calculation for Straight-Line is more straightforward than the Effective Rate Method outlined above. In the case of Straight-Line, the total net premium/discount is simply divided by the number of days from the dated date, to the final maturity date, thereby generating a level or “Straight-Line” law firm bookkeeping amortization across the life of the bonds. We can use the example of the Series 2022 Bonds we used for our effective interest rate calculations. See below for our total premium/discount amortization schedule for our Series 2022 issue using our Effective Interest Rate to Call method. Note the dynamic of the premium amortization rolling off on the call date, and the discount amortization continuing thereafter, reflective of the dynamic we discussed above.
The $10,000 difference between the sales price and the face value of the bond must be amortized over 10 years. (4) Bond premium in excess of qualified stated interest—(i) Taxable bonds—(A) Bond premium deduction. A deduction determined under this paragraph (a)(4)(i)(A) is not subject to section 67 (the 2-percent floor on miscellaneous itemized deductions). On a period-by-period basis, accountants regard the effective interest method as far more accurate for calculating the impact of an investment on a company’s bottom line.
It makes the bond more unattractive, and it is why the bond is priced at a discount. Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.
It is because the bond is overcompensating the bond-holder in terms of interest payments and the bond must fetch a premium. This is based on the most fundamental time value of money relationship in that the present value decreases with an increase in the interest rate. A bond is valued at the present value of its future cash flows (i.e. coupon payments and the par value) determined based on the market interest rate. When we issue a bond at a premium, we are selling the bond for more than it is worth. We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond.