Why Amortize a Discount on Bonds?

Why Amortize a Discount on Bonds?
••• richcano/E+/GettyImages

Amortization, in general, is a way of allocating total costs of a subject matter over some equal periods of time. For bond issuers, total bond discount is a form of interest expense in addition to cash payments based on the stated bond coupon rate.

A bond discount occurs when an issuer or borrower sells a bond and receives proceeds from investors or bondholders for less than the face value of the bond. By amortizing a bond discount, the amount of amortization for each period can be used to determine periodic interest expense as well as the changing bond carrying value over time.

Bond Discount

Bond issuers can sell their bonds at a discount, at face value or at a premium, depending on the difference between the documented bond coupon rate and the market interest rate at the time of the issuance. Bond premiums allow the bond issuer to sell at higher bond prices due to lower market rates, while bond discounts force the issuer to take less than the face value due to higher market rates.

Bond issuers often decide on the bond coupon rate according to the prevailing market interest rate. However, market interest rates change over time over the life of the bond.

If prior to a bond issuance the market interest rate increases, to avoid re-documenting the bond coupon rate to the higher market rate, the bond issuer can go ahead to sell bonds at a discount to compensate investors for the rate difference. A bond discount is the difference between the proceeds received during a bond issue and the face value of the bond, notes TreasuryDirect.

Discount Amortization

A bond discount is a hidden cost to the bond issuer, considering that it must later pay back investors more than it receives from them.

There are two basic methods of bond discount amortization for tax purposes: the straight-line amortization and the effective-interest-rate amortization methods. Under the straight-line method, the amount of periodic amortization is equal to the total bond discount divided by the number of interest-payment periods.

But when amortizing a bond discount under the effective-interest-rate method, the amount of periodic amortization is equal to the difference between the periodic coupon payment and the corresponding effective interest expense calculated as the period's discounted bond carrying value timed by the market interest rate. Considering its complexity, you may want to consult a CPA expert.

Interest Expense

When a bond is sold at a discount, the total effective interest expense on the bond for the issuer consists of the nominal interest expense that a bond issuer pays in coupon payments over time and the total amount of bond discount.

Typically, bond discount amortization helps to determine the real periodic interest expense. The effective interest expense on the bond for each payment period is then the sum of the periodic coupon payment and the allocated bond discount amortization. The amount of periodic bond discount amortization is dependent on the amortization method used.

According to the Corporate Finance Institute, you can find the bonds payable on the balance sheet in the liability section (usually considered as noncurrent or long-term liabilities) since it’s a liability account. CFI also says you can obtain the interest expense by multiplying the bonds payable account by the interest rate.

And when accounting for bond amortization, you will debit the interest expense side and credit the discount on bonds payable side if the bonds payable experienced a discount. As a result, your overall interest expense will increase, while the net book value of the bonds payable account will decrease.

Outstanding Carrying Value

Bond discount amortization also helps adjust the discounted bond carrying value over time. Because bonds sold at a discount will be repaid at their full face value, total bond discount is added back to arrive at the bond face value. The adjustment is done periodically by adding the allocated amount of bond discount amortization to the corresponding bond carrying value at the beginning of each interest-payment period.

Bond discount amortization has effects on both total interest expense and outstanding bond carrying value. Bond discount amortization over time increases bond carrying value, which in turn increases the total interest expense.

Bond Discount Straight Line Amortization Example

Suppose Company XYZ issues a ‌five-year, eight percent‌ coupon rate bond with a face value of ‌$200,000‌ for ‌$184,840‌. In that case, the discount on the bond is ‌$200,000 - $184,840‌, which is ‌$15,160‌.

If you opt for the straight-line amortization method, the annual amortization amount would be ‌$15,160/5‌, which is ‌$3,032‌, and translates to ‌$252.67 per month‌. And based on the stated interest rate, the company would pay interest worth ‌$16,000 each year‌ until the bond’s maturity date.

Therefore, the total interest expense for the year would be ‌$16,000 + $3,032‌, which is ‌$19,032‌ or approximately ‌$1,586 per month‌.

Bond Discount Effective Interest Rate Amortization Example

Suppose that the market rate was ‌10.8 percent‌ at the time company XYZ issued its ‌eight percent‌ coupon rate bond and received ‌$184,840‌. In that case, the annual interest payment expected will be ‌8 percent *200,000‌, which is ‌$16,000‌.

But since the market rate of interest was ‌10.8 percent‌ and the book value or carrying value of the bond was ‌$184,840‌, the interest expense at market rate is ‌10.8 percent * $184,840‌, which is ‌$19,962.72‌.

According to IFT, you will then subtract this amount from the expected coupon payment of ‌$16,000‌, resulting to ‌$3,962.72‌, which is the discount amount you will amortize in the first year. So, your total interest expense will be ‌$16,000 + $3,962.72‌ or ‌$19,962.72‌.