Amortization of Bond Premiums and Bond Discounts:
Understanding how bond premiums and discounts will be calculated and recognized on the financial statements will be critical to your understanding of this topic. Think of bonds as financial securities that are separate from its respective premium or discount amount. Premiums and discounts will be stated as separate line items on the company balance sheet and will be amortized by using the effective interest method (heavily tested), and at times, the straight-line method).
Bond Discounts – Bonds that are issued at a price that is less than its par value will be considered bonds issued at a discount. Additionally, bonds that are issued at a discount will be those with a market rate that is greater than the bonds stated rate.
Bond Premiums – Bonds that are issued at a price that is greater than its par value will be considered bonds issued at a premium. Additionally, bonds that are issued at a premium will be those with a market rate that is less than the bonds stated rate.
Amortization of Bonds Premiums & Discounts:
Bonds that result in a premium or a discount should be amortized by either applying the effective interest method or the straight-line method. For your exam, it is very important that you understand how to calculate the periodic amortization expense that will be applied to the premium or the discount.
Effective Interest Method – The effective interest method is used for the amortization of unamortized bond discounts and bond premiums. The effective interest that the issuer will pay is determined in the existing market, not in the bonds contract. If the coupon rate exceeds the market rate, the bonds will be selling at a premium. If the market rate exceeds the coupon rate, the bonds will be selling at a discount. The issuance price is determined by discounting the payments to the present value by applying the effective interest rate method. This is required for United States Generally Accepted Accounting Principles (GAAP). Interest expense under the effective interest method is computed as follows:
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