Straight Line Method of Bond Discount/Premium Amortization
In the straight-line method of amortization of bond discount or premium, bond discount or premium is charged equally in each period of the bond's life.
When the coupon rate on a bond is lower than the market interest rate, the bond is issued at a discount to par value. Alternatively, if the coupon rate is higher than the market interest rate, the bond is issued at a premium to its par value. The issue price and face value are equal only when market interest rate and the coupon rate are equal.
In case of a discounted bond issue, the carrying amount equals face value minus the discount on bond; and in case of a premium issue, the carrying amount equals face value plus unamortized premium.
Discount/premium amortization is the process through which the difference between face value and issue price is adjusted in the company's financial statements. There are two common methods: the effective interest method, and the straight-line method.
In case of all bonds, the interest paid or payable equals the product of face value and the coupon rate. However, the interest expense reported in the income statement depends both on the interest paid/payable and the amortization of discount or premium.
Straight-line amortization of bond discount
As a bond discount arises when coupon rate is lower than the market rate, the bond discount amortization must be added to the interest payment to arrive at market-equivalent interest expense.
Interest expense in case of a bond issued at discount = Interest payment + Amortization
The interest income on a debt-investment purchased at a discount must also be similarly higher than the interest income received. This is because we paid an amount lower than the face value of the bond at issue date but will get the full face value at maturity.
Straight-line amortization of bond premium
As a bond premium shows that coupon rate is higher than market interest rate, the interest expense must be lower than the payment. This means that the premium amortization is subtracted from interest payment to arrive at interest expense:
Interest expense in case of a bond issued at premium = Interest payment - Amortization.
The interest income on a debt-investment issued at premium must be similarly lower than interest received. This is because we paid an amount higher than the face value on purchasing the bond but on maturity we will get only the face value. Through the process of amortization, this difference is written off against periodic interest receipts.
Company DS issued 5-years 8%-annual coupon bonds with a face value of $100,000 for $92,420.
The difference of $7,580 between the face value of bond of $100,000 and the proceeds of $92,420 represents the discount on bond.
Since the bond has a life of 5 years, the annual amortization of bond discount would equal $1,516 ($7,580 divided by 5).
At the end of first year if interest payable is $8,000, Company DS would record its interest expense using the following journal entry:
Under straight line method, amortization of bond discount do not vary over the term of the bond.
Even though this example discusses only straight-line amortization of discount on a bond payable, amortization of bond premium only involves the same process.