Amortization of Bond Discount: Straight Line Method
When the coupon rate on a bond is lower than the interest rate prevailing in the market the bond is issued at a discount to par value. Alternatively, if the coupon rate is higher than the market interest rate the bond is issued at a premium to its par value. In both cases the carrying value of the bond is different from its face value. In case of issue at a discounted issue, the carrying amount equals face value minus the discount on bond; and in case of a premium issue, the carrying amount equals face value plus the amount of premium.
In both cases the interest paid or payable is based on the coupon rate which is the stated rate of the bond. However, the interest expense reported on the income statement is higher when the bond is issued at a discount to the par value by the amount of periodic amortization of bond discount. There are two methods for amortization of bond discount: the straight line method and the effective interest rate.
Straight line method
Under the straight line method of amortization of bond discount, the bond discount is written off in equal amounts over the life of the bond.
Company DS intended to issue a bond with face value of $100,000 having a maturity of 5 years and annual coupon of 8%. At the time of issue however, the market interest rate rose to 10% and the bond could fetch a price of $92,420 only.
The difference of $7,580 between the face value of bond of $100,000 and the proceeds of $92,420 represent the discount on bond. Since the bond has a life of 5 years, the annual amortization of bond discount would equal $1,516 ($7,580 divided by 5). At the end of first year if interest payable is $8,000 Company DS would record its interest expense using the following journal entry:
Under straight line method the periodic interest expense, interest payable and amortization of bond discount does not vary over the periods.
Written by Obaidullah Jan, ACA, CFA