Amortization of Bond Discount – Definition

Cite this article as:"Amortization of Bond Discount – Definition," in The Business Professor, updated February 24, 2019, last accessed May 27, 2020, https://thebusinessprofessor.com/lesson/amortization-of-bond-discount-definition/.

Back to: ECONOMICS, FINANCE, & ACCOUNTING

Amortization of Bond Discount Definition

Amortization is a process carried out to reduce the cost base of a bond for each period to reflect the economic reality of the bonds approaching maturity. The amortization is done at par. It is easy to prepare, and it is essential in calculating tax returns. It is also done annually and has different tax implications for the different bond types.

A Little More on What is Amortization of Bond Discount

A common factor between bond amortization and indirect cash flow method is that both of them involve interest expenses which are not in cash. In the indirect cash flow method, the expenses not in cash are adjusted to the net income (which is a profit in accounting that has expenses in cash and also not in cash). With the amortization of bonds, a discount or adjustment is promoted. The change to the net income is either an addition or subtraction depending on the bond redemption type.

The amortization of bonds is a process where the premium or discounted amount is assigned to the payment of interest of each period of the validity of the bond. The bonds can issue a discount or premium at par when the interest rate of the market is either higher or lower than the bond’s coupon rate.

Although nominal interest is the amount of interest payment amount in cash for each interest period, the discount amortization amount of a bond either adds or subtracts the payment of the coupon of the period to get the effective interest expense for calculating the net income.

The indirect method of cash flow

This method is used to calculate the cash flow from the various operating activities based on net income. Net income is not cash flow and is adjusted by the inclusion of cash inflows and outflows which don’t count as income and expenses and the exclusion of the non-cash income and expenses.

For example, when an expense not in cash is previously used in the calculation of net income, the expenditure amount not made in cash is added again to fix the cash flow. When a cash outflow is not considered as an expense and therefore not used in the calculation of net income, the outgoing amount of the non-cash must be subtracted from the net income to fix the cash flow.

Bond Discount

Discounted bonds’ amortization always leads to an effective interest expense that is higher than the payment of the bond interest coupon for each period. If a bond is sold at a discount, it means that the market interest rate is above the coupon rate. In this case, the amortization amount of the bonds’ discount for each period in the payment of the cash coupon is added to get the expense by real interest for net income calculation.

In the calculation of the cash flow, the non-monetary interest expenses are added in the amortization of the discounted bond to the net income.

Bonus on bonds

The amortization of the bonus on bonds leads to an interest expense less than the payment of the bond’s coupon interest for each period. If a bond is sold at a premium, it means that the market interest rate is less than the coupon rate. This leads to the subtraction of the bonus amortization amount for each period of the coupon payment in cash to realize the real expense and calculate the net income.

For cash flow calculation, the cash coupon payment that is not a financial expense in the bonus amortization premium is subtracted from the net income as cash outflow.

Amortization is necessary for tax purposes

In amortization, premium bondholders are required to reduce the cost base of their possessions in each tax reporting period. This coincides with the tax return period. The holders of discount bonds use an increase strategy where the base bonds’ base cost increase towards par because the bond moves toward maturity every year.

Tax effects of depreciation

According to the Internal Revenue Service, premium amortization in the fiscal accounts does not result in the capital loss for the client. With the discount vouchers, the cost base of a US savings bond is raised and is also a taxable capital gain. Investors who purchase only the bonds sold at par are those who avoid the inconvenience of reporting the changes for each bond.

Other tax effects

The price of bonuses varies each day, and the amortization is based on the reality the bonds must be exchanged in at maturity. The bond traders are required to use the new amortized cost in case a bond in negotiated before its maturity. A premium or discount bonus sold above the amortized is subjected to tax no matter the original cost.

Bonds that are sold below the amortized costs incur losses, and because of this, an essential concept of the exchange of taxes is utilized to avoid capital gains of the bonds. Exchange of taxes means that there are commercial ties with the losses of the same type of bonds to ensure the recognition of tax loss for purposes of income tax.

Depreciation rules to recognize the payment pair at maturity

Bonus premiums show that there is a decline in interest rates from when the bond was issued.  The discount vouchers are issued in areas with low-interest rates. The prices of premium and discount bonds remain even when the interest rates don’t change until maturity. The reason why the bonds prices are similar is that these prices become convergent as the bonds near maturity.

Majority of the bonds have early amortization characteristics for a specific date and price, and the premium bonuses amortize first to the call function. The remaining amortization is distributed at maturity, and the discount vouchers increase at maturity only.

References for Amortization of Bonds Discount

Academic Research on Amortization of Bond Discount

  • Using an online homework system to submit accounting homework: Role of cognitive need, computer efficacy, and perception, Peng, J. C. (2009). Journal of Education for Business, 84(5), 263-268. This is an investigation conducted to find out whether the efforts of students in working on their homework problems were affected by their cognition need, system perception, and computer efficacy when the instructors used an online system to collect their accounting homework.
  • A Note on the Issuance of Long‐Term Pure Discount Bonds, Livingston, M. (1979). The Journal of Finance, 34(1), 241-246. This paper attempts to show that this tax law means that at equilibrium, the issue prices of pure discount bonds have to be negative for a broad spectrum of tax rates.
  • Corporate debt coupon rate strategies, Racette, G. A., & Lewellen, W. G. (1976). National Tax Journal, 165-177. This paper examines the opportunities available for corporations to benefit their shareholders by issuing the bonds at other prices instead of the par value.
  • The taxation of bonds: The tax trading dimension, Strnad, J. (1995). Virginia Law Review, 47-116. This paper focuses on how the US tax authorities have strived to bring closer the income taxation bonds to the accretion tax model in the past twenty-five years.
  • The Miracle of Compound Interest: Interest Deferral and Discount after 1982, Canellos, P. C., & Kleinbard, E. D. (1982). Tax L. Rev., 38, 565. This paper explains the time value of money which is usually expressed as interest. It shows that an amount of money today is more valuable than that same amount of money one year from now.
  • Interest payments in the cash flow statement, Nurnberg, H., & Largay III, J. A. (1998). Accounting Horizons, 12(4), 407. This article explains how interest payments affect cash flow statements.
  • Cash flow comparability: Accounting for long-term debt under SFAS 95, Vent, G. A., Cowling, J. F., & Sevalstad, S. (1995). Accounting Horizons, 9(4), 88. This paper purposes to discuss four classification systems while documenting the corporations using each method and also evaluate the conceptual and practical advantages of each method.
  • Accounting for redeemable preferred stock: Unresolved issues, Nair, R. D., Rittenberg, L. E., & Weygandt, J. J. (1990). Accounting Horizons, 4(2), 33. This paper sheds light on the unsolved issues present in accounting for redeemable preferred stock.
  • Zero coupon bond arbitrage: An illustration of the regulatory dialectic at work, Finnerty, J. D. (1985). Financial Management, 13-17. This article shows how structural frictions in the capital markets of the world can lead to profitable arbitrage opportunities.
  • An analysis of original issue discount bonds, Kalotay, A. J. (1984). Financial Management, 29-38. This is an investigation on the interaction of interest rates and corporate income taxes on the price of original issue discount bonds.
  • Interest and Long-Term Bonds in Cash Flow Statement under S, Nurnberg, H. (1990). The CPA Journal, 60(1), 50. This article explains how the Statement of Financial Accounting Standard (SFAS) requires companies to provide cash flow statements for every period and include the results of every operation.
  • Tax-adjusted duration for amortizing debt instruments, Stock, D., & Simonson, D. G. (1988). Journal of Financial and Quantitative Analysis, 23(3), 313-327. This paper provides techniques, which are improved, to analyze the after-tax risk exposure of taxable institutions which hold amortizing instruments like commercial and real estate loans.

 

Was this article helpful?