Bond Amortization Schedule – Effective Interest Method

Bonds payable are issued by a business to raise finance. When they are issued at anything other than their par value a premium or discount on bonds payable account is created in the bookkeeping records of the business.

The effective interest method is one method of calculating how the premium or discount on bonds payable should be amortized to the interest expense account over the lifetime of the bond.

The effective interest method involves preparing a bond amortization schedule to calculate the interest expense based on the market rate at the time the bond was issued and the bonds book value. This interest expense is then compared to the actual interest payment based on the face value of the bond and the bond rate, and the difference gives the amount to be amortized to the interest expense account.

An example will help to make matters clearer.

Bonds Payable Issued at a Premium

Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 259,075 representing a market rate of 8%.

The premium on bonds payable is 259,075 – 250,000 = 9,075, and the initial bond accounting journal entry would be as follows:

The premium on bonds payable account has a credit balance of 9,075 which needs to be amortized to the interest expense account over the lifetime of the bond.

The actual semi-annual cash interest payments on the bond are of course based on the face value of the bond (250,000) and the bond discount rate (10%). Every six months the amount of 250,000 x 10% x 6/12 = 12,500 will be paid in cash to the bond holders.

Bond Amortization Schedule (Premium)

The bond amortization schedule is produced as follows

The table starts with the book value of the bond which is the face value (250,000) plus the premium on bonds payable (9,075), which equals the amount of cash received from the bond issue (259,075).

Each period, interest is charged on the opening book value of the bond at the market rate (8%), so for example, in period 1 the interest is 259,075 x 8% x 6/12 = 10,363. From this the cash payment of 12,500, representing the interest paid to bondholders based on the par value of the bond and the bond rate (250,000 x 10% x 6/12 = 12,500), is deducted. This leaves a ending balance which is the book value of the bond carried forward to the next period.

The final column headed premium, shows the difference between the interest calculated for the period and the payment for the period, and represents the amortization of the premium which needs to be credited to the interest expense account. For example, in period 1, the posting of the actual interest paid and the premium amortization shown in the bond amortization schedule is as follows:

For the sale of clarity, the posting of the actual interest expense (12,500) and the premium amortization (2,137) are shown separately in the journal above, in practice the net amount of 12,500 – 2,137 = 10,363 could be posted to the interest expense account

Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (10,363) to the interest expense account. In effect, because the bonds were issued at a premium and the business received more cash than the par value of the bonds, the cost (interest) to the business is reduced each period by the amount of the premium amortized.

From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is reduced to 250,000, and the premium on bonds payable (9,075) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash.

An identical process is followed if the bonds are issued at a discount as the following example shows.

Bonds Payable Issued at a Discount

Suppose, for example, a business issued 10% 2-year bonds payable with a par value of 250,000 and semi-annual payments, in return for cash of 241,337 representing a market rate of 12%.

The discount on bonds payable is 250,000 – 241,337 = 8,663, and the initial bond accounting journal entry would be as follows:

The discount on bonds payable account has a debit balance of 8,663 which needs to be amortized to the interest expense account over the lifetime of the bond.

The actual semi-annual cash interest payments on the bond are as before based on the face value of the bond (250,000) and the bond discount rate (10%). Every six months the amount of 250,000 x 10% x 6/12 = 12,500 will be paid in cash to the bond holders.

Bond Amortization Schedule (Discount)

The bond amortization schedule is produced as follows

The table starts with the book value of the bond which is the face value (250,000) less the discount on bonds payable (8,663), which equals the amount of cash received from the bond issue (241,337).

Each period, interest is charged on the opening book value of the bond at the market rate (12%), so for example, in period 1 the interest is 241,337 x 12% x 6/12 = 14,480. From this the cash payment of 12,500, representing the interest paid to bondholders based on the par value of the bond and the bond rate (250,000 x 10% x 6/12 = 12,500), is deducted. This leaves a ending balance which is the book value of the bond carried forward to the next period.

The final column headed discount, shows the difference between the interest calculated for the period and the payment for the period, and represents the amortization of the discount which needs to be debited to the interest expense account. For example, in period 1, the posting of the actual interest paid and the discount amortization shown in the bond amortization schedule is as follows:

For the sale of clarity, the posting of the actual interest expense (12,500) and the discount amortization (1,980) are shown separately in the journal above, in practice the net amount of 12,500 + 1,980 = 14,880 could be posted to the interest expense account

Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (14,880) to the interest expense account. In effect, because the bonds were issued at a discount and the business received less cash than the par value of the bonds, the cost (interest) to the business is increased each period by the amount of the bond discount amortization.

From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 250,000, and the discount on bonds payable (8,663) has been amortized to interest expense. As before, the final bond accounting journal would be to repay the face value of the bond with cash.

The effective interest rate method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative simpler method is the straight line method. The advantage of the effective rate method and the bond amortization schedule, is that the interest expense for the period reflects the book value of the bonds, in the case of a bonds issued at a premium, as the bond book value reduces towards the its face value, the interest expense reduces, and in the case of bonds issued at a discount, as the book value of the bond increases towards its face value, the interest expense increases.