Accounting with straight line amortization Straight line amortization is always the easiest way to account for discounts or premiums on bonds. Under the straight line method, the premium or discount on the bond is amortized in equal amounts over the life of the bond. In addition, it will also record a charge for the amortization of the discount. Premiums are amortized similarly.
Discounts and coupons
Effective interest amortization of discounts More frequently, businesses account for bond premiums or discounts under the effective interest method. This method is more mathematically complex, but can be done fairly quickly with the help of a finance calculator or Excel. Each year, we add the amortization to the carrying value and repeat these steps to find the next year's interest expense and discount amortization.
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Under the effective interest method, a company's interest expense and amortization amount will change every single year. Effective interest amortization of premiums Premiums are amortized in similar fashion to discounts under the effective interest method. Each year the amortization is subtracted from the carrying amount, and the new carrying amount is used to calculate interest expense and amortization for the next year.
Getting Started
The table below shows how this example bond would be accounted for over the full year period. Note that the only static figure is the amount of cash interest -- interest expense and amortization are different in every single year.
Straight line vs. Straight line amortization of premiums or discounts results in the same amount of interest expense, amortization, and cash interest in every single year until the bond is repaid.
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. Knowing this, you'll notice that the straight line method will result in more discount or premium amortization during earlier years than the effective interest method.
Bond yields generally converge to some extent to prevailing interest rates. After all, investors aren't going to be interested in a bond that pays less than they could get by keeping their money in the bank, so prices will fall on low-interest rate bonds as rates go up.
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Similarly, investors will pay a premium for high rate bonds when overall interest rates are low. Changing credit ratings and perceptions of the bond issuer's creditworthiness also play a role in individual bonds.
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Most investors buy bonds for current income and hold them till maturity. Regardless of what you pay for a bond, at maturity you will get back its full face value. If you buy a discount bond, you will have a capital gain; if you buy a premium bond, you will have a capital loss. But you could also lose money in a discount bond and come out ahead with a premium bond. Suppose you buy a discount bond because it looks cheap, but it is cheap because the issuer is in financial trouble.
What is the difference between a discount and a coupon?
If the issuer goes into bankruptcy, you stand to lose your entire investment. On the other hand, you could buy a premium bond instead of a certificate of deposit if the amount of interest you collect, less the capital loss at maturity, would still be more than the CD interest. Based in San Diego, Slav Fedorov started writing for online publications in , specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker.
Now working as a professional trader, Fedorov is also the founder of a stock-picking company.
What is the difference between Single Coupon codes and Bulk Coupon codes?
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