Amortizing the Bonds Discount or Premium
The straight-line method or the effective-interest method can be used to amortize the bond discount or premium. As we noted, if there are material differences between the two methods, the effective-interest method should be used. However, for ease of illustration, we will use the straight-line method in this article. Regardless of which method is used, the discount is amortized by debiting the Investment in Bonds account, and the premium is amortized by crediting the Investment in Bonds account. This procedure ensures that after the discount or premium is fully amortized, the investment account will reflect the bond’s maturity value.
To demonstrate these concepts, we will continue with the Cinzano Corporation example. The first interest payment day is on July 1, 2020, and the following entry would be made to record the receipt of the cash interest and the amortization of the discount:
In this entry, Cash is debited for $600, which is the full 6 months’ interest payment ($12,000 x .05). The Investment in Bonds account is debited for four months of discount amortization. The total discount is $240 and is amortized over the remaining 58 months of the bond’s life at the time of issue. This equals $4.14 ($240 + 58 months — $4.14) per month, and 4 months’ amortization from March 1, 2020 to July 1, 2020 is $16.56 ($4.14 x 4). This is rounded off to.$17 in the journal entry. Interest revenue is credited for $417. This $417 consists of 4 months’ cash interest plus $17 of the amortized discount. Note that from the investor’s perspective, the discount increases interest revenue, and from the issuer’s point of view, it increases interest expense.
Thereafter the Cinzano Corporation would make the following set of journal entries each year until the bonds mature or until they are sold. The corporation has a December 31 year-end.
These examples illustrate the accounting procedures for discounts. Premiums are handled in a similar manner except that the premium decreases interest revenue and is recorded by crediting the Investment in Bonds account.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.