"Amortization" is a term most business owners understand. It's a common accounting tool used alongside depreciation when an asset is being expensed over the years. When it comes to bonds, amortization is an adjustment used to account for the difference between the bond's stated interest rate and the amount for which the company actually sold it.
There are two ways to calculate a bond's cost amortization. The straight-line method is easier, but the effective interest rate method is more accurate.
Because interest rates fluctuate, the interest a corporation expects to pay on a bond (its face value) is sometimes higher or lower than the interest it actually pays to investors.
- Bond discount: When investors pay less than the face value of the bond, representing a higher interest rate than that for which the bond was issued
- Bond premium: When investors pay more for the bond, representing a lower rate than that for which the bond was issued
In the case of discounted bonds, the difference between the face value and the interest rate being paid out to investors is an additional expense to the company. As such, this is called an amortized cost.
This is the easy way to calculate an amortized cost. If a corporation issues financial statements only once a year, the amortization cost can be recorded annually or semiannually depending on how the bond's anniversary month aligns with the company's year end. If the company issues monthly statements, the bond's amortization cost should also be calculated monthly.
The journal entry for amortizing a bond's discount cost on a balance sheet is usually listed as an interest expense. The straight-line method uses the same amount of bond discount during each reporting period using the following formula:
Amortization = (Bond Issue Price – Face Value) / Bond Term
Suppose, for example, a company issues five-year bonds for $100,000, but due to a $3,000 discount, it receives only $97,000 from investors. Simply divide the $3,000 discount by the number of reporting periods. For an annual reporting of a five-year bond, this would be five. If you calculate it monthly, divide the discount by 60 months. The amortized cost would be $600 per year, or $50 per month.
The effective interest rate method is harder to calculate, but it has the advantage that it recognizes that the amount of interest paid on a bond increases each year. As such, the amortized cost of a bond in year one will be less than in the following years. As the book value of a company's bond increases, the amortized cost will also increase.
The bond discount of $3,000 is amortized over the life of the bond and is recorded as an interest expense. The amortization will make the bond's book value increase from $97,000 in year one to $100,000 just as it matures.
Find the interest payment paid out for the bond for each period. This should be the same amount each period. Enter this as a credit to the cash account on the date interest is paid.
This is the amount of interest investors were promised rather than the interest rate of the bond's face value. The effective interest rate is also known as the market interest rate of the bond.
Multiply the effective interest rate by the bond's book value at the start of the accounting period (which is the same as the book value at the end of the last accounting period). This is the interest expense for the current accounting period.
Subtract the interest payment for the current period from the interest expense for the current period to determine the amortization cost of the bond discount.
Alternatively, you can use a spreadsheet like Excel to prepare a bond amortization schedule. There are several templates available that are designed for loans. Simply use the difference between the face-value interest rate and the effective interest rate to determine the amortization cost.