Posted by When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. The discount refers to the difference in the cost to purchase a bond (its market price) and its par, or face, value. The issuing company can choose to expense the entire amount of the discount or can handle the discount as an asset to be amortized.
- If the corporation goes forward and sells its 9% bond in the 10% market, it will receive less than $100,000.
- An unamortized bond discount is reported within a contra liability account in the balance sheet of the issuing entity.
- For example, on February 1, the company ABC issues a $100,000 bond with a five-year period at a discount which it sells for $97,000 only.
- Suppose ABC Corporation issues a 3-year, $1,000 face value bond with a stated annual interest rate of 5%.
- Bond investors buy bonds at a discount from their face value, or par value, when the market interest rate exceeds the interest rate offered with the bonds on the date of issue.
The unamortized bond premium is what remains of the bond premium that the issuer has not yet written off as an interest expense. Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000. The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense.
Table of Contents
What is Unamortized Bond Discount?
The discount of $3,851 is treated as an additional interest expense over the life of the bonds. When the same amount of bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond). The carrying value of a bond refers to the amount of the bond’s face value plus any unamortized premiums or less any unamortized discounts. The carrying value is also commonly referred to as the carrying amount or the book value of the bond.
Unamortized bond discount definition
By the end of Year 3, the entire bond discount has been amortized, and the bond’s carrying value on the balance sheet equals its face value. Let’s dive into a more detailed example regarding the unamortized bond discount. For the second year, you’ve already amortized $6 of your regular bond premium, so the unamortized bond premium is $80 minus $6 or $74. Multiply $1,074 by 5% to get $53.70, subtract it from $60, and you can see that you’ll amortize $6.30 in the second year, leaving you with $67.70 in unamortized bond premium. Next, let’s assume that just prior to offering the bond to investors on January 1, the market interest rate for this bond increases to 10%.
The interest payments of $4,500 ($100,000 x 9% x 6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2026. In the next section, you’ll see an example of the calculation using the straight-line amortization method. Ultimately, the unamortized portion of the bond’s discount or premium is either subtracted from or added to the bond’s face value to arrive at carrying value. Based on the discounted future cash flows of the $300,000 bonds that have been issued, the effective interest rate can be calculated to be 6.9018% per annum. For example, on February 1, the company ABC issues a $100,000 bond with a five-year period at a discount which it sells for $97,000 only.
How to Calculate an Unamortized Bond Discount
These bonds have a maturity of three years with an interest rate of 5% per annum that is payable annually. It’s a monetary figure reflected by the amount paid in addition to the fair market value of a company when that company is purchased. Goodwill usually isn’t amortized (except by private companies in some circumstances) because its useful life is indeterminate.
The corporation decides to sell the 9% bond rather than changing the bond documents to the market interest rate. Since the corporation is selling its 9% bond in a bond market which is demanding 10%, the corporation will receive less than the bond’s face amount. The company usually issues the bond at a discount when the market rate of interest is higher than the contractual interest rate of the bond. After all, investors are unlikely to pay for the bonds at the face value if they can invest in other securities with similar risks but providing a better rate of return. To illustrate the discount on bonds payable, let’s assume that in early December 2021 a corporation prepares a 9% $100,000 bond dated January 1, 2022.
Buying below par enables investors to increase their effective return on investment on the interest the bond issuer pays. Because the issuer sold the bond for less than its face value, the issuer must reflect this discount on its balance sheet. The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the premium or discount account is the unamortized balance. The amortization of bond discount can be done with the straight-line method or the effective interest rate method depending on if the amount of discount is material or not. If the discounted amount is material the company need to amortize the bond discount with the effective interest rate method as it is a more accurate method compared to the straight-line method.
As mentioned, the unamortized bond discount is a contra account to the bonds payable on the balance sheet. Likewise, the carrying value of the bonds payable equals the balance of bonds payable less the balance of the unamortized bond discount. Unamortized bond discount is a contra account to bonds payable which its normal balance is on the debit side.
For tax purposes, you can reduce your $60 in taxable interest by this $6 for a net of $54. It’s the amount carried on a company’s balance sheet that represents the face value of a bond plus any unamortized premium or less any unamortized discount. You must also determine the amount of time that has passed since the bond’s issuance plus how much of the premium or discount has amortized. If current market rates are lower than an outstanding bond’s interest rate, the bond will sell at a premium. If current market rates are higher than an outstanding bond’s interest rate, the bond will sell at a discount. Bond investors buy bonds at a discount from their face value, or par value, when the market interest rate exceeds the interest rate offered with the bonds on the date of issue.
Accounting for the Unamortized Bon Discount
Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount https://personal-accounting.org/ even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented. Auditors prefer that a company use the effective interest method to amortize the discount on bonds payable, given its higher level of precision. The second way to amortize the discount is with the effective interest method. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period.
Instead, they sell at a premium or at a discount to par value, depending on the difference between current interest rates and the stated interest rate for the bond on the issue date. On an issuers balance sheet, this item is recorded in a special account called the Unamortized Bond Premium Account. This account recognizes the remaining amount of bond premium that the bond issuer has not yet amortized or charged off to interest expense over the life of the bond. An unamortized bond discount is reported within a contra liability account in the balance sheet of the issuing entity. Bond prices move up and down constantly, and it’s common for bond investors to face situations where they have to pay more than the face value of a high-interest bond in order to persuade the current owner to sell it.