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BONDS AND SINKING FUNDS

Amortization of Bond Premiums and Discounts

*APPENDIX:

The origin and calculation of bond premiums and discounts were discussed in Section

15.2. We will now look at the premiums and discounts from an accountant’s perspective. The point of view and the schedules developed here provide the basis for the

accounting treatment of bond premiums, discounts, and interest payments.

Amortization of a Bond’s Premium

Bonds are priced at a premium when the coupon rate exceeds the yield to maturity

required in the bond market. Suppose that a bond paying a 10% coupon rate is

purchased three years before maturity to yield 8% compounded semiannually. The

purchase ...view middle of the document...

After the final interest payment, the bond’s book

value will be reduced to the $1000 face value which is received along with the last interest payment. The process of reducing the premium in this way is called amortization of

the bond premium. The details of the treatment of each coupon payment and the

reduction of the bond premium are often tabulated in a bond premium amortization

schedule. In the following example, we will develop a full amortization schedule for the

bond used in the preceding discussion.

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Individual bond investors view the “excess” interest each period as a partial offset for the $52.42 capital loss that

they will incur when the bond is redeemed for its $1000 face value at maturity.

On his income tax returns, an individual investor reports the full coupon payments year by year as interest

income. In the year the bond matures, he is allowed to claim the full $52.42 capital loss.

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CHAPTER 15

CONSTRUCTION OF A BOND PREMIUM AMORTIZATION SCHEDULE

Example 15AA

Prepare a complete bond premium amortization schedule for the 10% coupon bond in the preceding discussion. It was purchased for $1052.42 on a date three years before maturity to yield 8% to maturity. How

much of the $300 received in coupon payments over the three years would accountants treat as interest

income?

Solution

Coupon

number

Coupon

payment

Interest on

book value

Discount

amortized

Book value

of bond

Unamortized

discount

0

1

2

3

4

5

6

—

$ 50

50

50

50

50

50

$300

—

$42.10 ①

41.78

41.45

41.11

40.75

40.39

$247.58

—

$7.90 ②

8.22

8.55

8.89

9.25

9.61

$52.42

$1052.42

1044.52 ③

1036.30

1027.75

1018.86

1009.61

1000.00

$52.42

44.52 ④

36.30

27.75

18.86

9.61

0.00

① Interest on book value = 0.5 ϫ Yield rate ϫ Book value after previous coupon payment

= 0.04 ϫ $1052.42 = $42.10

② Premium amortized = Coupon payment Ϫ Interest on book value = $50 Ϫ $42.10 = $7.90

③ New book value = Previous book value Ϫ Premium amortized = $1052.42 Ϫ $7.90 = $1044.52

④ Unamortized premium = Current book value Ϫ Face value = $1044.52 Ϫ $1000 = $44.52

Of the $300 received in coupon interest payments, accountants would treat

$247.58 as interest income during the three years. The remaining $52.42 would be

treated as a refund of the bond’s premium.

Amortization of a Bond’s Discount

Bonds are priced at a discount when the coupon rate is less than the yield to maturity

required in the bond market. Suppose that a bond paying a 10% coupon rate is purchased three years before maturity to yield 12% compounded semiannually. The purchase price that provides this yield to maturity is $950.83.

The accounting view is that a period’s earned interest is the amount that gives the

required rate of return on the bond investment. The interest payment after the first six

months that would, by itself, provide the required rate of return (12% compounded

semiannually) on the amount...

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