Amortization of Bond Costs - Explained
What is Amortization of Bond Costs?
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Table of ContentsWhat is Amortization of Bond Costs?How Does Amortization of Bond Costs Work?Straight-line bond discount or bond premiumActual Interest MethodAnalysis Amortization of bond costsAcademic Research on Amortization of Bonds
What is Amortization of Bond Costs?
Amortization of bond costs is a process of adjusting the nominal interest expense of a bond to the actual interest expense.
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How Does Amortization of Bond Costs Work?
There are only two methods amortizing bond costs:
Straight-line bond discount or bond premium
When this method is used to amortize the premium or discount, the amortization amount is the same each time. Under this method, the necessary project calculations done by companies which issue bond premiums or amortizations are as follows:
- Amortization of coupon interest for the current period = face value interest period's coupon rate
- Current premium or discount amortization amount = Total premium or discount amount/number of interest periods
- Current interest expense = (current coupon interest - current period premium amortization amount) or (current coupon interest + current period discount amortization amount)
- Amortization premium or discount at the end of the period = book value or discount of unexpired bonds at the beginning of the period - amortization or discount for the current period
- The book value of bonds payable at the end of the period = (the book value of the bonds payable at the beginning of the period - the amortization of the current period premium) or (the book value of the bonds payable at the beginning of the period + the amortization of the current period discount)
Companies that amortize bonds on a straight-line basis do not charge a very high-interest expense amount. In situations where interest expense for each period is supposed to be related to the book value of the bond when the book value is large, then the interest expense is also supposed to be large, and the converse is true. Bond issuance companies which use the straight line method accrue the interest expense of each period to the carrying value of the bonds. This leads to a consistent decline in the real interest rates since the amortized bonds have the same discount and this is not reasonable.
Actual Interest Method
This method calculates the accrued interest expense for each bond period by multiplying the initial book value of each bond period by the actual interest rate. The formula used to calculate the essential items of the bond premium or discount amortization is similar to that of the straight line method except for two items which are:
- Interest expense for the current period = book value of bonds payable at the beginning of the period actual interest rate
- Current period premium (or discount) amortization amount = (current coupon rate - current interest expense) (negative value is discount amortization amount)
In this method, the calculated accrued interest expense will increase or decrease gradually because the bond's book value also decreases and increases with the bond premium or discount. This means that the calculated interest expense is also reduced or increased by the period. The amortization of premium or discount for each period is the difference between the accrued interest expense for every period and the accrued interest expense calculated at the coupon rate. After the amortization of the corporate bond premium or discount under this method, the resulting corporate bond premium which is adjusted up or down is multiplied by the fixed interest rate. This means that the amount of actual interest expense must be increased or decreased for the period from which the fixed interest paid for each period is subtracted. The discounted amortization amount is also increased and decreased accordingly.
Analysis Amortization of bond costs
The company issues bonds which are calculated and paid interest at the par value of these bonds and each interest period's coupon rate within the prescribed interest period. The interest paid or payable on corporate bonds is a financing fee. Any interest that is paid or payable by the company in each period consists of current bond interest expense, but the amount of the two is only equal if the bonds are issued at a low price. When a bond is issued at a premium or discount, the branches of each period are equal, and the bond interest expense is determined through adjusting the interest paid or payable on the bond in the current period by amortizing the premium or discount. For companies issuing bonds, the bond premium is recovering the interest paid in advance by the purchaser of the bond and is supposed to be added on a period of interest. This ensures the reflection of the interest of each actual burden. The corporate bonds issued at a premium or discount have a purpose of balancing the interest payments by bond companies and interest income of the investment companies so that both of them can eventually pay interest charges and income at market rates.