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Amortization of Bond Costs Defined
Amortization of bond costs is a process of adjusting the nominal interest expense of a bond to the actual interest expense.
A Little More on Amortization of Bond Costs
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.
Reference for Amortization of Bonds
Academic Research on Amortization of Bonds
- Coping with the risk of interest-rate fluctuations: a note, Bierwag, G. O., & Kaufman, G. G. (1977). The Journal of Business, 50(3), 364-370. This is a paper showing how an investor can immunize a portfolio of coupon bonds through the selection of a portfolio which has a duration equivalent to the holding period.
- An analytical model of risky yield curves, Kolari, J. W. (1987). Journal of Financial Research, 10(4), 295-303. This paper presents a proposal of a multi-period certainty equivalent model of present valuation which takes a dynamic approach to valuation instead of a recursive approach that was traditionally employed in financial economics.
- The Presentation of Corporate Income and Earned Surplus, Kelley, A. C. (1949). The Accounting Review, 24(3), 285-289. This article discusses the corporates income and the earned surplus. Earned surplus is the total company profits, after the payment of dividends, since a company was incepted.
- Reaching for yield in the bond market, Becker, B., & Ivashina, V. (2015). The Journal of Finance, 70(5), 1863-1902. This is a study of the propensity of investors to buy riskier assets to achieve better yields in the corporate bond market.
- The Europe 2020 Project Bond Initiative, Rossi, E. (2015). Infrastructure Project Finance and Project Bonds in Europe (pp. 63-79). This article studies the purpose of the new instrument of the Project Bond Initiative (PBI) that was developed by the EU and EIB jointly. The apparatus was established with the intention of relaunching and revitalizing the project bond market in Europe that stagnated after the financial crisis.
- The Treatment of Unamortized Discount and Expense Applicable to Bonds Refunded before Maturity, Lemke, B. C. (1947). The Accounting Review, 22(4), 379-384. This paper studies how the significant fall in interest rates that started in the 1930s led to an exercise by corporations of calling bonds before maturity in cases where those provisions had been incorporated in the bond terms.
- SEC Administrative Policy on financial statements, Greidinger, B. B. (1942). Journal of Accountancy (pre-1986), 73(000003), 219. This article examines the policy of the SEC in interpreting the Securities Act and the Security Exchanges Act for the full and fair disclosure of the character of securities sold in interstate and foreign commerce.
- Premature Retirement of Bonds Outstanding-Adjustment of Unamortized Bond Expense, Sandberg, E. L. (1932). The Accounting Review, 7(1), 67. This paper focuses on the recognition of the gains or losses of a bond that is retired prematurely.
- Grading CPA Papers, Kohler, E. L. (1932). Accounting Review, 67-69. This study focuses on how CPA exams are scored, weighted and finally graded.
- APPLYING BINOMIAL TREE TO PRICE MORTGAGES, CALIBRATE IMPLIED PREPAYMENT-ADJUSTED SPREAD (PAS), and OPTIMIZE MORTGAGE …, Xie, C. (2008). This paper introduces a new measure for mortgagors to identify the wealth of mortgages which is the implied prepayment-adjusted spread (PAS). It applies the method of interest rate binomial trees that are based on benchmark yield curves like the treasury yield curve.
- Taxation–Deduction of Amortized Commissions on Bonds Issued Prior to 1913, Kostelanetz, B. (2014). St. John’s Law Review, 9(2), 25. The article shows three issues of bonds were sold by the taxpayer and an additional amount paid to bankers as a commission for marketing the bonds.
- In the Age of a 3.8 Percent Net Investment Income Tax, It’s Still Advisable to Amortize Bond Premiums., Witner, L., & Gainor, M. (2014). Journal of Taxation of Investments, 31(2). This paper presents a summary of NIIT, the requirements of bond premium amortization, and considers a hypothetical high-income investor while using a model that gives a conclusion stating that it is advisable to amortize the premium.