When companies issue a bond, they do so with a face value and a coupon rate: the terms that dictate the bond’s yield to potential investors. However, once they reach the market, bonds can trade at a premium or a discount, depending on these conditions. In doing so, companies need to think about how they will approach bond amortization: the process of achieving full repayment of the bond on their books.
There are several ways to approach bond amortization, including linear and effective interest rate methods. Both are recognized under generally accepted accounting principles (GAAP). How a company chooses to account for amortization of obligations depends on the nature of the obligation, the financial strategy of the company, and the amounts involved.
Here’s a closer look at bond amortization: how it works, amortization methods, and the impact of this process on a company’s financial accounting.
What is depreciation?
The concept of amortization has two parts: interest and principal. Payments against the bond spend more from interest to principal over time. This is because the payment amount remains static while the principal slowly decreases.
Depreciation is a concept that you can best understand by example. Most people know about amortization if they have a fixed rate mortgage. In fact, every new homeowner receives an amortization schedule for their mortgage after their home closes.
Mortgage payment example
Bailey buys a house for $ 132,000, at an interest rate of 3.375%. Her monthly mortgage payment is $ 588. For his first mortgage payment, $ 214 goes to principal and $ 374 to interest. For her 60e payment, $ 252 will go to principal while $ 336 will go to interest. And for her 180e payment, $ 353 will go to principal while $ 235 will go to interest. This shift will continue, moving more toward the principal until she repays the loan.
The benefits of amortizing bonds
Companies can amortize bonds as a means of reducing the risk of default. Since the principal of the loan is repaid over time, it is less of a burden on the business than making a lump sum payment. In addition, amortization shortens the term of the obligation, which helps companies better control interest charges. In addition, this shorter obligation period protects against interest rate risk. In many ways, bond amortization benefits investors and bond companies.
Straight-line amortization of bonds
As is the case with something like depreciation, straight-line amortization of bonds involves the same amount of interest charges each year over the life of the bond. This ensures a consistent payout amount throughout the life of the bond, with no lump sum or lump sum payments at the end. It can apply to both discounted bonds and those that sell at a premium.
Example of a discounted bond
There is a $ 10,000 bond that is currently valued at $ 9,500. It is a four year bond with a 10% coupon rate. Each year, the cash payment for this bond will be $ 1,000 (10%). However, this will also incur an additional expense for the bond discount, in this case, $ 175 per year. Therefore, the interest charge for this bond will be $ 1,175 per year.
Example of a premium bond
There is a $ 10,000 bond that is currently valued at $ 10,500. It is a four year bond with a 10% coupon rate. Each year, the cash payment for this bond will be $ 1,000 (10%). However, since it sells for a premium, this amount is subtracted from the cash payment. In this case, the interest charge for the bond will be $ 9,825 per year.
Straight-line amortization is a quick and convenient way to amortize a bond, but it’s not always the most accurate or cost-effective way for companies to approach bond amortization. Instead, many companies choose an accelerated amortization schedule.
Effective amortization of interest
Another way to amortize an obligation is to effective amortization of interest. This method is more complex than straight-line bond amortization, but also provides a more accurate representation because it takes into account the present value.
To calculate the effective amortization of interest, investors must find the present value of the bond’s total cash payments, as well as its face value, using current market interest rates. The addition of these values gives the total present value of the bond. If this number is lower than the nominal value of the bond, it is discounted; but if the number is higher, the bond sells at a premium.
If the bond sells at a discount, the company will amortize the amount of the discount over the life of the bond at the effective market rate. And if it sells at a premium, the company subtracts the premium amount over the life of the bond from the effective market rate. In either case, the closer the maturity date, the closer the interest charge will be to the face value of the bond.
Accounting for amortization of bonds
Companies issue corporate bonds to finance projects and expansions. They choose bonds because they offer a predictable way to account for funds: both credit and debit point of view. The business knows exactly how much money is coming in and how much to repay over a predetermined period of time.
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The method of amortization of bonds chosen by the company depends on many factors. For example, this includes whether it trades at a premium or a discount, as well as the bond’s maturity date. In either case, proper amortization of the obligation ensures that companies correctly recognize these liabilities.