In the past post we covered the basics of bonds payable….In this post we will look into the amortization methods of bond premium or bond discount and their treatment on the financial statements.
How do you amortize Bond Discount / Bond Premium?
When bonds are issued at par the book value and face value of the bond is same. Therefore the interest expense will be the same as coupon payments to the bondholders.
When a bond is issued at a discount or premium the book value and face value differ. In such a case the market rate is different from the stated rate on the bond and therefore, the interest expense differs from the coupon of the bond.
Bond Premium or bond discount is systematically amortized over the life of the bond by deducting the difference between interest expense and coupon or adding it, respectively.
So why do we amortize bonds? What is amortization of bond premium or bond discount? How would you calculate the amount of premium amortized? We have already noted in the previous post that a bond tends to par as it tends to maturity. Why is that so?
First let us take the case of bond premium. When a bond is issued at a premium the market yield is less than the coupon rate, therefore the interest expense is less than the coupon. We amortize the bond premium by deducting from the book value of the bond liability the difference between the coupon and the interest expense. Hence, the bond liability reduces every year until it reaches par on maturity.
Let us understand this intuitively. When coupon is paid out every year in excess of the market yield, the premium paid by the bondholder is being returned back to him to the extent of excess coupon paid over and above the market yield. Therefore, the bond liability of the issuing company reduces every year to that extent until par is reached which is repaid at maturity.
Now let us take the case of amortizing the discount on bonds payable. When the market yield demanded is higher than the coupon rate, the bond is issued at a discount. In this case, the interest expense is higher than the coupon payment. Bond Discount is amortized by adding to the book value of the liability the excess of the interest expense over and above coupon. This is because when interest expense is paid in excess of the coupon the demand for excess yield over and above the coupon is being satisfied by the excess amount paid. Therefore the bond issuer’s bond liability increases every year by the difference in the interest expense and coupon.
Treatment of amortization of Bond premium and bond discount on the Financial Statements
Two methods used for amortizing bond premium/bond discount is the effective interest rate method and straight line method. So what is the effective interest rate method of amortization?
Effective interest rate method uses the market yield in effect when the bonds were issued to calculate the interest expense of the current period. Straight line method on the other hand evenly amortizes the premium/discount over the life of the bond similar to the straight line method of depreciation.
The effective interest rate method is required under IFRS and preferred under US GAAP.
The manner in which cash interest paid is reported on cash flow statement differs under IFRS and US GAAP. Under US GAAP cash interest paid must be reported as an operating cash outflow. Under IFRS it can be reported either as an operating cash outflow or financing cash outflow.
Derecognition of Debt
A firm can either leave the bond issued to be outstanding until maturity or choose to redeem them before maturity by calling the bond. If the bond remains outstanding until maturity, the issuer pays the bondholders the face value at maturity. Repayment appears on the cash flow statement as a financing cash outflow. At maturity the bond premium or bond discount is fully amortized so that the net book value equals face value. Therefore on the balance sheet, at maturity the repayment reduces the book value of the liability by the face value.
Should the issuer choose to redeem the bonds before maturity, a gain or loss is recognized by subtracting the redemption price from the book value of the bond liability.
Gain or loss on redemption is reported on the income statement as part of continuing operations.
On the cash flow statement, redemption price is reported as a financing cash outflow. Under the indirect method of presenting the cash flow statement, gain or loss is subtracted from or added to net income for arriving at cash flow from operations.
Thats all in this post…thanks for reading…stay tuned for more posts in this series…
For solved examples please refer to the CFA Institute books or CFA study materials. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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