Straight Line Bond Amortization

If bonds payable are issued by a business at a value other than their par value a premium or discount on bonds payable is created in the accounting records of the business.

The straight line amortization 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 straight line bond amortization method simply involves calculating the total premium or discount on the bonds and then amortizing this to the interest expense account in equal amounts over the lifetime of the bond.

The following example demonstrates the method.

Straight Line Bond Amortization of a Premium

Suppose, for example, a business issued 8% 2-year bonds payable with a par value of 120,000 and semi-annual payments, in return for cash of 122,204 representing a market rate of 7%.

The premium on bonds payable is 122,204 – 120,000 = 2,204, and the initial bond accounting journal entry would be as follows:

The premium on bonds payable account has a credit balance of 2,204 which needs to be amortized to the interest expense account over the lifetime of the bond. As the 2 year semi-annual bond has 4 payment periods, using the straight line bond amortization method, the premium is simply amortized at the rate of 2,204 / 4 = 551 each 6 month period.

The actual semi-annual cash interest payments on the bond are of course based on the face value of the bond (120,000) and the bond discount rate (8%). Every six months the amount of 120,000 x 8% x 6/12 = 4,800 will be paid in cash to the bond holders. The following straight line bond amortization schedule demonstrates how the bond book value (122,204) reduces to its par value (120,000) over the lifetime of the bond.

Straight Line Bond Amortization Schedule (Premium)

The straight line bond amortization schedule is produced as follows

The table starts with the book value of the bond which is the par value (120,000) plus the premium on bonds payable (2,204), which equals the amount of cash received from the bond issue (122,204).

Each period the interest expense (4,249) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) less the premium amortized (551).

The final column headed premium, shows the difference between the interest expense and the payment for the period, and represents the amortization of the premium (551), which needs to be credited to the interest expense account each period.

For each of the four periods the bond accounting journal to record the interest and premium amortization will be as follows:

For the sale of clarity, the posting of the actual interest expense (4,800) and the premium amortization (551) are shown separately in the journal above, in practice the net amount of 4,800 – 551 = 4,249 could be posted to the interest expense account

Notice that the effect of this journal is to post the interest of 4,249 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, this is demonstrated in the following straight line bond amortization schedule.

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 120,000, and the premium on bonds payable (2,204) 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.

Straight Line Bond Amortization Schedule (Discount)

Suppose, for example, a business issued 8% 2-year bonds payable with a par value of 120,000 and semi-annual payments, in return for cash of 117,848 representing a market rate of 9%.

The discount on bonds payable is 120,000 – 117,848 = 2,152, and the initial bond accounting journal entry would be as follows:

The discount on bonds payable account has a debit balance of 2,152 which needs to be amortized to the interest expense account over the lifetime of the bond. Using the straight line bond amortization method, the discount is simply amortized at the rate of 2,152 / 4 = 538 each 6 month period.

The actual semi-annual cash interest payments on the bond are of course based on the face value of the bond (120,000) and the bond discount rate (8%). Every six months the amount of 120,000 x 8% x 6/12 = 4,800 will be paid in cash to the bond holders. The following straight line bond amortization schedule demonstrates how the bond book value (117,848) increases to its par value (120,000) over the lifetime of the bond.

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 par value (120,000) less the discount on bonds payable (2,152), which equals the amount of cash received from the bond issue (117,848).

Each period the interest expense (5,338) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) plus the discount amortized (538).

The final column headed discount, shows the difference between the interest expense and the payment for the period, and represents the amortization of the discount (538), which needs to be credited to the interest expense account each period.

For each of the four periods the bond accounting journal to record the interest and discount amortization will be as follows:

For the sale of clarity, the posting of the actual interest expense (4,800) and the discount amortization (538) are shown separately in the journal above, in practice the net amount of 4,800 + 538 = 5,338 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 (5,338) 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 straight line bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is increased to 120,000, and the discount on bonds payable (2,152) 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 straight line bond amortization method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative more acceptable method is the effective interest rate method. The advantage of the straight line method, is that the amortization is simple to calculate and the interest expense and therefore the bond accounting journals, are the same for each period over the lifetime of the bond.