BONDS AND SINKING FUNDS
Amortization of Bond Premiums and Discounts
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.
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.
CONSTRUCTION OF A BOND PREMIUM AMORTIZATION SCHEDULE
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
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...