Companies sell bonds to investors in order to raise funds for company activities. Each bond includes a face value, a stated interest rate and a maturity date. The face value refers to the denomination for which the company issues the bond. The company sells the bond for a different price than the face value. If the bond selling price exceeds the face value, the bond sells at a premium. If the face value exceeds the bond selling price, the bond sells at a discount. The company amortizes the premium or discount over the term of the bond. Two different methods exist for amortizing the bond premium or discount.
The straight line method of amortization calculates an equal dollar amount to amortize each period. The accountant calculates the total premium or discount by subtracting the face value from the selling price. The accountant divides the total premium or discount by the total number of periods remaining on bond term. This calculates the amortization amount.
The effective interest method uses the market interest rate of the bond. The market rate of interest refers to the actual interest rate paid based on the book value of the bond, not the face value. The book value of the bond equals the face value of the bond plus the premium or minus the discount. The company calculates the amount of premium or discount to amortize by multiplying the market interest rate by the book value of the bond.
These amortization methods contain several similarities. The amortization methods both record the amortization as interest. If the company amortizes a premium, the interest reduces net income. If the company amortizes a discount, the interest increases net income. The end result of amortizing the premium or bond remains the same for both methods. The book value of the bond will equal the face value of the bond.
Several differences exist between the two methods. The straight line method requires less complex calculations and includes equal amortization amounts. The effective interest method requires the accountant to recalculate the amortization amount each period. The amortization amount varies each period. The interest recorded with each amortization entry remains the same using the straight line method. It declines with the effective interest method.