Investment amortization mostly involves fixed-income investments purchased at either a discount or premium to face value, when the market's prevailing interest rate differs from an investment's coupon rate. Investment amortization allocates total discount or premium to each interest-paying period to determine the real interest, which has tax implications as revenue for investors or expense for borrowers. This is done through effective interest method as used in accounting for periodic valuation of investments held to maturity, according to the 2001 book Intermediate Accounting. In the amortization process, the proration for each period is either added to or subtracted from the discount or premium price. When an investment is fully amortized, its outstanding or carrying value at the end of the investment term would be equal to the investment's face value.
Gather all necessary data on the investment. These include purchase price, coupon rate, effective interest rate, the periodic compounding period -- yearly, monthly or at any other interval -- total investment compounding periods and the face value amount.
Calculate both the periodic effective interest and the cash coupon payment, starting with the first period. Suppose the investment pays 5 percent in coupon rate every year and is a two-year investment, the purchase price on the investment is a discount of $980 to the $1,000 face value and the corresponding prevailing market rate is 6.0923 percent. The effective interest for the first year would be $980 x 6.0923 percent = $59.70 and the coupon payment in cash is $1,000 x 5 percent = $50.
Apply the interest difference to the discount purchase price. The interest difference between effective interest and cash payment is $59.70 - $50 = $9.70. The difference is added to the discount purchase price of $980 and the result is $9.70 + $980 = $989.70, which is the investment's outstanding value at the end of the first year and would be the principal amount basis for calculating the effective interest of the next period.
Calculate the effective interest for the second year. Using the investment outstanding value of $989.70, the second year effective interest is $989.70 x 6.0923 percent = $60.30. Note that the cash payment for the second year remains the same at $50.
Apply the second-year interest difference to the outstanding investment value. The second-year interest difference is $60.30 - $50 = $10.30. Add the difference to the outstanding investment value of $989.70 at the beginning of the period and the result is $10.30 + $989.70 = $1,000. Once the outstanding investment value reaches the face value amount, the amortization is complete.
For investments purchased at a premium, the periodic cash payment would be larger than the effective interest in each period. However, all the steps in completing the amortization process for discount investments still apply, except that each interest difference is subtracted from its corresponding investment outstanding amount at the beginning of the period.
The effective interest method is the preferred method over a simple straight-line method. According to Accounting Coach, the effective interest method is the systematic way for investment amortization, which matches the real interest with an investment's carrying value in any given period.
- "Intermediate Accounting"; Donald E. Kleso, Jerry J. Weygandt, Terry D. Warfield; 2001
- Accounting Coach: Effective Interest Rate Method of Amortization
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