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This section explains how to use present value techniques to determine the price of bonds issued at premium. In this case, however, the bonds are issued when the prevailing market interest rate for such investments is 10%. The primary advantage of using the effective interest rate is simply that it is a more accurate figure of actual law firm bookkeeping interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage. You can find the amount of discount amortization by taking the interest expense we calculated ($9,385.54) and subtracting the cash interest ($9,000), resulting in $385.54 of discount amortization in year one.
- Prepare a bond premium amortization schedule for the first 4
interest periods. - But the company is only paying interest on $100,000—not on the full amount received.
- It received $91,800 cash and recorded a Discount on Bonds Payable of $8,200.
- The premium of $7,722 is amortized using either the straight-line method or the effective interest method.
- The $10,000 difference between the face value and the carrying value of the bonds must be amortized over 10 years.
- Under § 1.1016–5(b), A’s basis in the bond is reduced by $1,024.99 in 1999.
The interest payments made to the bondholders are calculated using the coupon rate and the bond’s face value. For example, for a bond with a face value of $1,000 paying a 5% coupon rate, the coupon per year will be $50. The table below shows how this example bond would be accounted for over the full 10-year period.
Bonds Issued at a Discount Example: Carr
For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly. Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes. A bond trading for less than 100 would be priced for less than $1,000; it is considered a discount.
Figure 13.10 illustrates the relationship between rates whenever a premium or discount is created at bond issuance. Multiply the $100,000 by the 5% interest rate and $5,000 is the amount of interest you owe for year 1. Subtract the interest from the payment of $23,097.48 to find $18,097.48 is applied toward the principal ($100,000), leaving $81,902.52 as the ending balance. In year 2, $81,902.52 is charged 5% interest ($4,095.13), but the rest of the 23,097.48 payment goes toward the loan balance.
Bonds Issued at a Premium
The premium on bonds payable account is called an adjunct account because it is added to the bonds payable account to determine the carrying value of the bonds. This entry is similar to the entry made when recording bonds issued at a discount; the difference is that, in this case, a premium account is involved. For 1999, A includes in income $8,141.68, the qualified stated interest allocable to the period ($9,166.67) offset with bond premium allocable to the period ($1,024.99). Under § 1.1016–5(b), A’s basis in the bond is reduced by $1,024.99 in 1999. Where P is the bond issue price, m is the periodic market interest rate, F is the face value of the bond and c is the periodic coupon rate. We can use our same example Series 2022 issue to show the calculations.
Due to a change in market yield, the change in market value of the bond is reported in the income statement as a gain or loss. The effective interest method results in a different amount of interest expense and amortization each year. The only thing that doesn’t change from year to year is the amount of cash interest paid on the bond. To calculate cash interest, we multiply the face value of the bonds ($100,000) by the coupon rate (9%) to get $9,000. The cash interest is calculated by taking the coupon rate of the bond (9%) and multiplying it by the bond’s face value ($100,000), resulting in $9,000 of cash interest. Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest.