The company issues bonds to increase its capital. However, market interest rates and other factors influence the selling price of bonds to be higher (premium price) or lower (discounted price) than their face value. Bond premiums and discounts are amortized, (or spread) on the financial statements over the bond's maturity. The carrying value of a bond is the net difference between the nominal value and the unamortized portion of the premium or discount. Accountants use this calculation to record the loss or profit retained by the company due to the issuance of bonds at a premium or discount price in the financial statements.
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Part 1 of 4: Understanding Bond Basics
Step 1. Learn about bonds
There are three important characteristics of all types of bonds. The first is the par value or face value, which is the total amount of money the bond represents. The second is the interest rate, and the last is the maturity of the bond in years.
Step 2. Understand how companies issue bonds
Companies sell bonds to investors to raise capital. Investors buy bonds at a certain price, and then receive interest payments every six months from the bond issuer. On the maturity date of the bonds, investors also receive cash at the face value of the bonds.
For example, let's say a company needs funds to raise capital. Therefore, the company issues bonds worth Rp. 200,000,000, with an interest rate of 10%, and will mature in 5 years. Investors buy bonds. The company obtains money from investors and improves its capital, but must be returned with interest. After 5 years, the bonds mature. The company now has to pay the nominal value of the bonds plus 10% interest to investors
Step 3. Understand the factors that affect bond prices
If the bond interest rate differs significantly from the overall market interest rate for the same bond, the bond will be sold at a premium or discount. Interest rates change every day. When interest rates rise, bond prices fall. If interest rates fall, bond prices will rise. Thus, if the inflation rate rises, bond prices will also fall, and vice versa. Finally, bond issuers and certain bonds are assessed by a credit rating agency. Issuers with high credit scores will have high bond prices as well.
- Returning to the previous example, the company issues a $200,000,000, 10%, 5-year bond. For example, an investor may receive an investment return of better than 10% because market interest rates are high. Investors will not buy bonds at par because it is more profitable to invest in other instruments. Thus, the company sells the bonds for Rp. 2,000,000 below the par price. Now, investors can buy IDR 200,000,000 worth of bonds for IDR 198,000,000. When the bond matures 5 years later, the investor receives IDR 200,000,000 plus 10% interest.
- If the market interest rate is less than 10%, corporate bonds pay better than other investments. Therefore, the company sells the bonds at a premium price of IDR 2,000,000 higher than the nominal value. Now, the purchase price of bonds for investors is IDR 202,000,000. when the bond matures, the investor receives IDR 200,000,000 plus 10% interest.
Step 4. Know the meaning of carrying value
The carrying amount is calculated by the bond issuer, or the company that sells the bonds with the aim of accurately recording the premium or discount value of the bonds in the financial statements. Bond premiums or discounts are amortized (or spread) over their maturity. Accountants use this calculation to spread the effect of the premium or discount over the bond's maturity on the financial statements.
The carrying amount (or book value) of a bond at any time is equal to the face value less any discount or plus any remaining premium. Before calculating the carrying amount of a bond, you need some information and a few simple calculation steps
Step 5. Understand amortization
Amortization is an accounting method that reduces the cost of an asset over time. Amortization spreads the discount or premium on a bond over its maturity. On the maturity date, the carrying amount of the bond equals its face value.
For example, let's say a company sells $200,000,000, 10%, and 5-year bonds at a $2,000 discount. the company received Rp198,000,000 from investors. This transaction is recorded as a liability in the financial statements. The Rp2,000,000 discount is considered an asset and is amortized, or recorded in the financial statements in increments over the bond's maturity. The difference between the nominal value and the unamortized portion of the discount or premium at this time is the carrying amount
Step 6. Understand the difference between carrying value and market value
The market value of a bond is the price an investor pays to buy a bond. This price is influenced by the market for example interest rates, inflation and credit ratings. Bonds can be sold at a discount or at a premium, depending on market conditions. On the other hand, carrying value is the accountant's calculation to record the impact of premiums or discounts on the financial statements of bond issuers.
The carrying amount is the net value of the bonds issued to the issuer of the bonds. This value is calculated based on the amount of premium or discount on the bonds, the length of the bond's maturity, and the amount of amortization that has been recorded
Part 2 of 4: Accounting Treatment for Premiums and Discounts
Step 1. Prepare the initial journal entry on the date of the bond sale
Both premium and discount, the company must make an initial journal entry when the bond is sold by recording cash received and the premium or discount given. Bonds payable will always be recorded on credit at the face value of the bonds.
- In the previous example, the company issued bonds of Rp. 200,000,000 so it recorded Bonds Payable of Rp. 200,000,000 on credit.
- If the company sells the bonds at a discount of Rp. 2,000,000, the company will record cash received on debit of Rp. 198,000,000 (Rp. 200,000,000 - Rp. 2,000,000) and premium or discount payable on debit of Rp. 2,000,000.
- Then, if the company sells the bonds with a premium of Rp. 2,000,000, the company will record cash received on debit of Rp. 202,000,000 (Rp. 200,000,000 + Rp. 2,000,000) and premium or discount payable on credit of Rp. 2,000,000.
Step 2. Calculate the amount of premium/discount to be amortized
To make the next entry, the company must determine the amount of premium or discount to be amortized. This amount will reduce the balance of premium or discount payable. If the company uses the straight-line depreciation method, the amount of this account will be the same for each reporting period. This example uses that method, for reasons of simplicity.
- Say in the example of issuing a $200 bond, the bond makes interest payments twice a year. That is, the company will make a journal twice that records interest expense. Additional entries must be made at the same time according to the amortized amount of the premium or discount.
- Because the maturity of the bonds and interest are paid semi-annually, the amortization is done at 1/10 of the premium or discount in each period (5 years x 2 times a year). Thus, according to the previous example, the amortization of the premium or discount would be recorded at CU200,000 (Rp2,000,000 x 1/10).
Step 3. Calculate interest expense
You need the amount of interest payments to bond investors in the same period to be able to report amortization accurately. Interest is paid once or twice per year (period). Calculate the annual interest expense by multiplying the nominal interest rate by the face value of the bond. Divide the result by two to find the semiannual interest expense.
For example, for a IDR 200,000,000 bond, the annual interest is obtained by multiplying the nominal interest rate (10%) by the face value. IDR 200,000,000 x 10% the result is IDR 20,000,000. Thus, the half-annual interest expense recorded is half, which is Rp. 10,000,000
Step 4. Record the amortization of the discount/premium in the annual report
Each year, the company must record the interest expense paid from the sale and maintenance of bonds. This interest expense is included in interest payments to bond investors plus or minus amortization of premiums/discounts. For semiannual interest payments, the company records both payments in the same year separately, along with the amortization of each.
- The recording is the interest expense on the debit of the total interest expense consisting of semi-annual interest payments plus a discount or minus a premium.
- If there is a discount, the company records cash on credit in the amount of interest expense and amortized amount of discounted bonds payable. In semiannual interest payments the amounts on both records are the same.
- If there is a premium, the bond premium payable is recorded on the debit of the amortization amount and cash on the credit of the amount of interest expense paid.
- For example, let's use the previous $200,000,000 bond at a discount. The recording is a semiannual interest payment of Rp10,000,000 plus amortization discount on debit and interest expense of Rp10,200,000 on credit. The company also recorded discounted bonds payable on credit of Rp200,000 and cash on credit of Rp10,000,000.
Part 3 of 4: Calculating Carrying Value
Step 1. Determine the maturity of the bond
Find out if the bond is selling at par, premium or discounted. Determine the time that has elapsed since the issuance of the bonds. To calculate the carrying amount of a bond, you need to know the amount of premium or discount that has been amortized, which depends on the amount of time that has passed since the bond was issued.
Step 2. Calculate the amortized portion of the premium or discount
Most premiums or discounts are amortized using the straight-line method. This means that the amortization in each period is the same. For example, suppose a 10 year bond was issued 2 years ago. Amortization for two years has been recorded, and the remaining 8 years of amortization. You need to know the amount of the remaining unamortized amortization to calculate the carrying amount of the bond.
For example, two years ago the company issued a 10-year bond with a premium of Rp80,000. each year, an amortization of CU8,000 is recorded (CU80,000/10 years = CU8,000 per year). If two years have passed, it means that the company has recorded an amortization of Rp. 16,000 (Rp. 8,000 x 2 years) and the remaining unamortized premium of Rp. 64,000 (Rp. 8,000 x 8 years = Rp. 64,000)
Step 3. Calculate the carrying amount of the bonds sold at a premium
For example, the company sells bonds for Rp. 1,000,000 10%, 10 years for Rp. 1,080,000 and two years have elapsed since the issuance date. Calculate the premium by subtracting the selling price from the face value of the bond (Rp1,080,000-Rp1,000,000=Rp80,000). Premium of Rp80,000 will be amortized over the maturity period of Rp8,000 per period. Because two years have passed, the company has recorded an amortization of Rp. 16,000 (Rp. 8,000 x 2 years) and the remaining unamortized premium of Rp. 64,000 (Rp. 8,000 x 8 years = Rp. 64,000). The carrying amount of the bonds is equal to the face value of the bonds plus the remaining unamortized premium. Therefore, the carrying amount of the bonds is the nominal value of Rp. 1,000,000 + the remaining unamortized premium of Rp. 64,000 = Rp. 1,064,000.
Step 4. Calculate the carrying amount of bonds sold using the same method
Subtract the face value of the bond by the unamortized discount. For example, a company sells $1,000,000, 10%, and 10 years at $920,000, or a discount of $80,000 and two years have elapsed since the bond issuance. Annual discount amortization of Rp. 8,000. A two-year amortization has been recorded, leaving eight years remaining at CU8,000 x 8 = CU64,000. The carrying amount of the bonds is CU1,000 – CU64,000 = CU936,000.
Part 4 of 4: Understanding Bond Amortization
Step 1. Know the difference between the straight-line method of amortization and the effective interest method
The straight-line method records the same amortization amount in each period until the bonds mature. The effective interest method records interest expense based on the carrying amount of the bonds and the amount of interest paid. Both methods record the same amount of interest payments each period. The difference is how many amounts are recorded in each period and how they are calculated.
In America, the straight-line method is permitted by SEC regulations called Generally Accepted Accounting Principles (GAAP). In other countries, the effective interest method may be required to comply with International Financial Reporting Standards (IFRS)
Step 2. Understand the amortization of discounted bonds using the straight-line method
The straight-line method records the same amount of interest expense in each interest payment period. The discounted debt and bond balances will decrease each period by the same amount until the bond matures and the balance is zero. Under this method, the carrying amount of the bonds at maturity is the same as their face value.
For example, the company sells a $200,000,000, 10%, 5-year bond for $198,000. a discount of Rp2,000,000 (Rp200,000,000-Rp198,000,000) and an amortization of Rp400,000 (Rp2,000,000/5) for each amortization period
Step 3. Understand the amortization of the bond premium using the straight-line method
The method is similar to straight-line amortization of discount. During the maturity of the bond, the balance of premium payable and bonds continues to decrease by the same amount each period. When the bond matures, the balance of the premium payable and the bond is zero, and the total carrying amount equals the face value.
For example, the company sells a $200,000,000, 10%, 5-year bond for $202,000,000. The premium is Rp2,000,000 (Rp202,000,000-Rp200,000,000) and the amortization is Rp400,000 (Rp2,000,000/5) for each amortization period
Step 4. Understand the amortization of premiums or discounts using the effective interest method
The effective interest rate is the percentage of the bond's carrying amount over the bond's maturity. This value appears when the bond is issued and remains constant in each period. Under this method, interest expense is recorded as a percentage of the bond's carrying amount on a constant basis.
- Multiply the carrying amount of the bond at the beginning of the period by the effective interest rate to calculate the bond's interest expense.
- Multiply the face value of the bond by the contractual interest rate to determine the bond interest paid.
- Decrease the amortization amount by calculating the difference between the bond interest expense and the bond interest paid.
