This method calculates premium/discount amortization for each maturity individually and combines them into a full amortization schedule for the entire issue. A bond is sold at a discount when its coupon rate is lower than the market rate. Investors pay less than the bond’s face value because its interest payments are less attractive. The discount is gradually amortized, meaning it is added back to the bond’s carrying value over time. A bond is sold at a premium when its coupon rate is higher than prevailing interest rates, meaning investors are willing to pay more than the bond’s face value. The premium amount represents the extra amount above par that the bondholder pays to receive higher interest payments.
#1 – Allocation of the Interest on the Bonds
When purchasing a bond at a premium, the investor is essentially paying more for its promised future cash flows than the bond’s stated value. Over time, the difference between the bond’s market price and its face value decreases as the bond approaches maturity. For example, suppose that the market interest rate increases from 10% to 12%. This will cause the bond value of a 10-year bond with a face value of $1,000 and a coupon rate of 8% to decrease from $877.1 to $783.86, using the bond value formula. This is because the higher market interest rate will increase the discount rate and reduce the present value of the future cash flows from the bond.
Amortization Calculations in the Constant Interest Method
Amortization of premium on bonds payable is the process of gradually reducing the premium on bonds payable over the bond’s life until the bond’s carrying value equals its face value at maturity. The premium arises when the bonds are Budgeting for Nonprofits issued at a price higher than their face value due to a lower market interest rate than the stated interest rate on the bond. The bond amortization calculator calculates the total premium or discount over the term of the bond.
Step 2
Similarly, suppose that the credit risk of the issuer increases, which makes the investors demand a higher return for investing in the bond. This will also cause the bond value to decrease, as the discount rate will increase. The bond amortization table shows how the book value of the bond increases from $877.1 to $1,000 over the 10 periods, as the bond discount of $122.9 is amortized. The interest expense of the bond increases from $87.71 to $100 over the 10 periods, as the book value of the bond increases.
In the realm of digital marketing, influencer partnerships have emerged as a powerhouse strategy… Boost your confidence and master accounting skills effortlessly with how to calculate premium amortization CFI’s expert-led courses! Choose CFI for unparalleled industry expertise and hands-on learning that prepares you for real-world success.
As mentioned earlier, if market interest rates fall, any given bond with a fixed coupon rate will appear more attractive, and it will result in the bond trading at a premium. So, if a bond comes with a face value of $1,000, and is trading at $1,080, it offers an $80 premium. Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price “plus accrued interest.” The issuer must pay holders of the bonds a full six months’ interest at each interest date.
Feature Flash: Integrating Debt & Cash Management
- In the case of a bond, “n” is the number of semiannual interest periods or payments.
- Valley collected $5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.
- With the straight-line method, DebtBook allows users to choose when to start amortizing the premium/discount.
- We will also compare the bond value with the bond price, which is the amount that investors are willing to pay for the bond in the market.
- At the end of the first period, the bond’s value would be reduced by $1,000, resulting in a new value of $9,000.
The straight-line method is a linear method that Accounting Periods and Methods is the simplest to use. Using the straight-line method, bond amortization results in bond discount amortization values that are equal throughout the term of the bond. Assume an investor purchases a bond for $10,500, with a face value of $10,000 and a five-year maturity period.
