Why amortize bond discount

Bond discount amortization is the process through which bond discount written off over the life of the bond. There are two primary methods of bond amortization: straight-line method and effective interest rate method. An amortization schedule lists bond payments, bond discount amortization and interest expense for each period.

This causes the bond to sell at a price lower than the face value of the bond and the difference is attributable to bond discount. Similarly, bond premium occurs when the coupon rate is higher than the market expectation of required return. Due to higher coupon rate, there is high demand for the bond and it sells for a price higher than the face value of the bond.

The difference between the face value of the bond and the bond price is called bond premium. Learn more. Knowledge Base Financial Statements Balance Sheet Long-term Liabilities Bond Discounts and Premiums Amortization Bond Discounts and Premiums Amortization When bonds are sold at a discount or a premium, the interest rate is adjusted from the face rate to an effective rate that is close to the market rate when the bonds were issued.

Effective Interest Method. The amount of periodic bond discount amortization is dependent on the amortization method used. Bond discount amortization also helps adjust the discounted bond carrying value over time. Because bonds sold at a discount will be repaid at their full face value, total bond discount is added back to arrive at the bond face value. The adjustment is done periodically by adding the allocated amount of bond discount amortization to the corresponding bond carrying value at the beginning of each interest-payment period.

Bond discount amortization has effects on both total interest expense and outstanding bond carrying value. Bond discount amortization over time increases bond carrying value, which in turn increases the total interest expense. An investment and research professional, Jay Way started writing financial articles for Web content providers in As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger.

The calculations for an amortizing loan are similar to that of an annuity using the time value of money , and can be carried out quickly using an amortization calculator.

Amortization of debt affects two fundamental risks of bond investing. First, it greatly reduces the credit risk of the loan or bond because the principal of the loan is repaid over time, rather than all at once upon maturity, when the risk of default is the greatest. Second, amortization reduces the duration of the bond, lowering the debt's sensitivity to interest rate risk , as compared with other non-amortized debt with the same maturity and coupon rate.

This is because as time passes, there are smaller interest payments, so the weighted-average maturity WAM of the cash flows associated with the bond is lower. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly. Treating a bond as an amortized asset is an accounting method used by companies that issue bonds.

It allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its face value and sold at a premium when the price received is greater than face value. If a bond is issued at a discount —that is, offered for sale below its par or face value—the discount must be treated either as an expense or it can be amortized as an asset.

In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company's interest expense on its income statement. The interest expense, a non-operating cost, reduces a company's earnings before tax EBT and, therefore, the amount of its tax burden. Amortization is an accounting method that gradually and systematically reduces the cost value of a limited-life, intangible asset.

Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.

Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period.