Straight Line Amortization of Bond Premium or Discount - Online Tutor, Practice Problems & Exam Prep

Understanding bond amortization is crucial in accounting, particularly when dealing with discounts and premiums. When bonds are issued at a premium, the cash received exceeds the face value, leading to a premium on bonds payable. The straight-line method amortizes this premium evenly over the bond's life, impacting interest expense calculations. Conversely, bonds issued at a discount result in cash received being less than the face value, requiring similar amortization techniques. Key formulas include cash interest calculations and amortization rates, ensuring accurate financial reporting and adherence to accounting standards.

Straight Line Amortization:Bond Premium

All right. So we used the straight line method of amortization when we first discussed discounts on bonds and premiums on bonds. Let's go ahead and compare the two right now, and let's do a focus video on the straight line amortization. So the first thing we want to remember is our summary here of why we have discounts and premiums. And it's all related to our interest rate. So remember, when the stated rate equals the market rate, so a situation where they both equal 10%, well, the price of the bond today, it's going to be equal to the face value of the bond, right? So that's when we have a face-value bond, sometimes called a par value bond. Well, what about this next situation? Where we have a stated rate less than the market rate. So now the bond is offering 8%, when similar bonds on the market are offering 10%. People would rather buy the other bonds, the bonds on the market than our bond, right? So in that case, our bond will be selling at a price less than the face value. This will be at a discount. And finally, the final situation was where the stated rate was greater than the market rate, and this is where the price of the bond will be greater than the face value, right? Greater than the face value. And this was the premium situation, right? Because if this bond is offering 12% interest when other similar bonds are offering 10% interest. Well, investors would rather buy our bond because they're paying more interest, so they would sell at a premium, okay?

So let's start with the premium bonds and let's discuss this straight line amortization all in detail a little more. So like our similar example before, on January 1, 2018, ABC Company issues $50,000 of 9% bonds maturing in 5 years. Interest is payable semiannually on January 1st and July 1st. The market interest rate was equal to 8%. The bonds were issued at 108. So we know this is a premium, first, because the stated rate on the bonds is greater than the market rate. Right? So since these bonds are paying more than the market, well, they're going to sell for more than their face value. And then we also know it's a premium for sure because they were issued at a price above 100%. They were issued at a price of 108% of their face value. So how much cash came in? Well, like we learned before, we would do the 50,000 times 108%, which is 1.08. And that comes out to 54,000 in cash, right? So since the cash is 54,000, but later on when we pay off these bonds, we are only going to pay off 50,000. We have this premium of 4,000. Right? So our journal entry as we learned, we had a debit to cash for the 54,000 we just calculated. We had a credit to bonds payable. Right? We are going to have this liability in the future. And as we discussed, this is always going to be the principal amount of the bonds. This 50,000 up here that is always what goes into the bonds payable, and then we have to balance this out with the 4,000 going to the premium on bonds payable. So that 4,000 is the premium on bonds payable and that's it for our issuance entry for a premium bond, right? Where we have our cash come in, in this case, 54,000. Bonds payable is a liability that increased by 50,000. But then we also had plus the premium of 4,000 gave us a net increase of 54,000 to the liabilities there for this bond payable. Right? So let's go ahead and pause here and then we'll discuss the amortization of this $4,000 premium. Let's discuss the amortization over the life of the bond.

Straight Line Amortization:Bond Premium

So the amount of amortization that goes into our interest expense entry is always going to follow this formula we have here. Notice in the top, it's going to be the total bond premium or discount. And this was the amount at issuance, right? So from our issuance entry, how much was that total bond premium? And then we are going to disperse it over the life of the bond. So we want to be careful that it's the total number of interest periods, right? It might not be years because if we have semi-annual periods, well, we're going to have to multiply the number of years by 2. Right? So let's go ahead and see it in this example. So we've got that same information and now it's the July 1st entry, right? Now it's been 6 months. We are paying semi-annual interest, so it's time to pay the first 6 months of interest. So how much is that interest going to be? The cash interest that we pay is always going to be the principal amount, the 50,000 times the bonds, stated rate 9%. And in this case, we divide by 2, right? We divide it by 2 because it's for 6 months, not the full year. And we're going to get cash interest of 2,250. Now, what about that amortization of the premium? Well, we're going to use this formula that we have above. And that tells us the total bond premium goes in our numerator, divided by the total interest periods. And this will tell us per period. And that's why it's straight line because it's the same amount every period. So we have 4,000 in the total premium, and we're going to divide it by 10 interest periods, right? Because it's a 5-year bond, 2 interest periods per year, 10 total interest periods. So it comes out to 400 per period will be amortized. Okay? So each period is a 6-month period, and will amortize 400 into the interest expense. So, every time we do an interest expense journal entry, we're going to have interest expense as a debit. Right? Because it's an expense, so we know it's going to be the debit in the entry. And when we pay cash, what we are going to have credit to cash. Right? This could also be interest payable. If we didn't pay the cash immediately, say we were just accruing for the 6 months interest, well, we could either credit cash if we paid it, or we'll credit interest payable if we're going to pay it soon, maybe the following day or something like that, like we've seen in previous examples. Okay? So we know our cash is 2,250. So that's going to be a credit to cash. Now, what about this premium amortization? How do we remember if it's going to be a debit or a credit in the interest expense entry? Well, it has to be the opposite of what our original entry was. Remember, when we have a premium, it's increasing the liability. Right? Because we received more money than the face value of the bonds. So as we saw above, we had the 4,000 that was an additional credit entry. So to start amortizing it and getting rid of that credit, we need debits. So we're going to have debit here to the premium on bonds payable, and it's going to be lowering its value. Right? So it started at 4,000. Well, we're taking 400 out of that 4,000 now. And the interest expense is what's going to be left over. So whenever we do the straight line method, we calculate the amount using, the formula principal times the stated rate. And then you possibly divided by 2 if it's semiannual. If not, you do the full year's interest if it's for the annual interest payment. So you divide by 2 if it's for the half year like in this example. And the premium, well, that's going to use our formula that we have at top. The formula at the top in the box, right? In that green box at the top, that's how we calculate that 400. Okay? And then what's left over? Well, we plug this in. This is the plug-in this situation that makes it balance. Okay? This is how we're always going to do it when we're doing the straight line method. Now, if you guys have to learn the effective interest method, you're going to see it's a little bit different in the calculation. Don't get too caught up with it at this point. Just focus on the straight line method. So this is how we do it. We calculate our cash interest, use the formula for our amortization and then the interest expense will be the plug. Okay? So just like we've seen before, let's go ahead and fill this in. We had cash come out for 2,250 and that was a decrease to our assets for the cash we actually paid. The premium, what is that doing to our liabilities? Well, we're amortizing the premium, right? It had a 4,000 credit balance and we're getting rid of it, right? It's lowering our liabilities. We had a $54,000 balance for the carrying value of the bonds. Well, we took 400 out of that, right? As we amortize the premium. So that's lowering our liabilities by 400 as we amortize it. And the interest expense over here. Well, expenses they lower our equity, right? 1,850. You can see that 1,850 and that's a decrease to our equity right there. Cool? Alright. So let's go ahead and now let's move on to discounts. Let's see the same thing using the straight line method for discounts on bonds payable.

Straight Line Amortization:Bond Discount

So when we issue the bonds, we're always going to have our issuance entry where we receive cash and make our bonds payable, and we're either going to have a discount or premium depending on the stated rate and the market rate. Okay. So let's go ahead and check it out. On January 1, 2018, ABC Company issued 50,000 of 9% bonds maturing in 5 years. This 9%, that's our stated rate on these bonds. Interest is payable semiannually on January 1st and July 1st. The market rate is equal to 10%. This is the market rate on these bonds, right? And notice the stated rate is less than the market rate. So our bonds are only paying 9% when the market is paying 10%, they're going to sell at a discount, and we can tell it's a discount because they're issued at 94%, right? 94% of their $50,000 value. So the cash we receive is going to be equal to the 50,000 times 94% which is 0.94. So let's see what that comes out to. 50,000 times 0.94 equals 47,000. Okay? So that's the amount of cash we're going to receive, but that's not the amount we pay back when these mature, right? We're going to have to pay back the full 50,000. So we're going to debit cash here because we received cash of 47,000 and we're going to credit bonds payable. Now how much is the bonds payable amount? You guys should have this down by now, right? We're going to put the entire 50,000 into bonds payable here. Cool? So we credit bonds payable this liability for 50,000. Well, we need 3,000 more in debits and guess what? That's our discount on bonds payable. Notice in this case, since we have a discount, we have a debit here and it's lowering the value of our liability, where with the premium it was increasing the value of our liability. So let's see how that works here. The cash went up by 47,000, but notice what happens with our liabilities. We had bonds payable for 50,000, right? But then we have less the discount because this is a debit, right? We have a credit in bonds payable and a debit in the discount. Well, the discount is going to lower this value by that 3,000 leaving us with 47,000 in our liabilities there. That's the increase. Cool? Let's pause here, and then we'll deal with the interest expense.

Straight Line Amortization:Bond Discount

Alright, now let's do the same thing with the interest expense, but now for the discount example. Notice we've got the same formula. The amortization is always going to be that total amount of the premium or the discount divided by the total interest periods. Cool? So let's do that here. Notice we have semiannual interest again, right? So that means twice per year. So our cash amount of interest that we're going to pay, well, that's going to be the 50,000 times 0.09 and we're going to divide that by 2, right? Because it's for half a year and we'll get the 2,250 in interest. Now how about the amortization? In this case, we had 3,000 of total discount divided by the 10 periods, right? We've got 5 years, 2 interest periods per year. That's 10 total periods. So that's 300 per interest period that we're going to amortize of our discount. Okay? 300 getting amortized per period. So let's go ahead and go straight to our journal entry. We know we're paying cash, right? We're going to credit cash for 2,250 and we're going to in this case, remember our discount had a debit balance, right? It was lowering the value of our liability with a debit balance. Well, to get rid of that debit balance, we need credits. So now we need to credit the discount on bonds payable to start getting rid of that debit balance. So this will be a 300 credit to discount on bonds payable, and then our debit we always have interest expense as a debit, and notice this is again our plug. So we need to add the other two numbers, right? We found our cash, we found our discount. Well, the interest expense is just the sum of the 2 of them. 2,550. So just like we had before with the cash, we use our formula: Principal times stated rate and then we're going to divide by 2 if it's semiannual. If it's semiannual, then we divide by 2. And the 300, well that comes from the formula in the box, right? This number is a plug that balances our equation. So let's go ahead and fill these out. Our cash went down by 2,250. Now what about with the discount? We have this credit to the discount. Well, this is increasing our liability, right? Before we had the 50,000 in bonds payable and 3,000 in the discount. Well, we've credited 300 out of the discount, so there's less discount. Our liabilities are increasing by that 300. Right? So that's less of a discount, so our liabilities are getting closer to that 50,000 value that it originally had, and now our interest expense, well, that's equity, right? Interest expense, and that's for the 2,550, and that's a decrease to equity right there. So right behind me, 2,550 decreased to equity. Right? From the interest expense. So we stay balanced here. The left side went down by 2,550, the right side went down by 2,250. Everything balances here. Alright, so let's go ahead and do a practice problem now related to the straight-line method.

Jayster Company issued bonds at a discount. The semi-annual journal entry for interest expense will include:

• A. A debit to Discount on Bonds Payable
• B. A debit to Premium on Bonds Payable
• C. A credit to Discount on Bonds Payable
• D. A credit to Premium on Bonds Payable

Here’s what students ask on this topic:

What is the straight-line method of amortizing bond premiums and discounts?

The straight-line method of amortizing bond premiums and discounts involves spreading the total premium or discount evenly over the life of the bond. For a bond issued at a premium, the premium amount is subtracted from the interest expense each period. Conversely, for a bond issued at a discount, the discount amount is added to the interest expense each period. This method ensures that the interest expense remains consistent over each period, simplifying financial reporting and ensuring adherence to accounting standards.

How do you calculate the amortization of a bond premium using the straight-line method?

To calculate the amortization of a bond premium using the straight-line method, you divide the total bond premium by the number of interest periods over the bond's life. For example, if a bond has a $4,000 premium and 10 interest periods (5 years with semi-annual payments), the amortization per period is calculated as:

$\frac{4000}{10}=\; 400$

This $400 is then subtracted from the interest expense each period.

What is the journal entry for amortizing a bond premium using the straight-line method?

The journal entry for amortizing a bond premium using the straight-line method involves debiting the premium on bonds payable and crediting the interest expense. For example, if the premium amortization per period is $400, the entry would be:

Debit: Premium on Bonds Payable $400

Credit: Interest Expense $400

This reduces the premium on bonds payable and the interest expense by the amortized amount.

How do you calculate the interest expense for a bond issued at a discount using the straight-line method?

To calculate the interest expense for a bond issued at a discount using the straight-line method, you first determine the cash interest payment by multiplying the bond's face value by the stated interest rate and adjusting for the payment period. Then, add the amortized discount amount to this cash interest. For example, if a bond has a face value of $50,000, a stated rate of 9%, and a discount of $3,000 over 10 periods, the calculations are:

Cash Interest: $\frac{50000}{0.09}÷\; 2\; =\; 2250$

Amortized Discount: $\frac{3000}{10}=\; 300$

Total Interest Expense: 2250 + 300 = 2550

What is the impact of bond premium amortization on financial statements?

Bond premium amortization reduces the interest expense reported on the income statement, which in turn increases net income. On the balance sheet, the premium on bonds payable account decreases over time, reducing the carrying amount of the bond liability. This process ensures that the bond's book value approaches its face value by maturity, providing a more accurate representation of the company's financial obligations.