Updated July 6, 2023
Definition of Amortization of Bond Premium
The companies sometimes issue bonds at a price higher than their face value, and the difference between the issue price and the face value is known as the bond premium.
The Premium must be amortized or written off by the company in its books of accounts over the bond’s life systematically. The amortization of bond premium refers to charging the Premium as a finance cost over the bond’s life.
Explanation
It has to be done when bonds are issued at a premium above their face value. Then, the company issuing such bonds needs to write off the bond’s Premium over its life in the books of accounts. The technique through which such write-off is done is known as amortization.
The amortization can be done equally in each accounting period up to the end of the bond’s life. Alternatively, it can be done based on a reduced balance of bonds. The amount that is amortized in each period forms part of the expenses.
How to Amortize Bond Premium?
One needs to calculate the number of bond premiums to amortize bond premiums. The same can be calculated by reducing the face value of the bond from its issue price.
Bond Premium = (Issue Price – Face Value) × No. of Bonds Issued
Once the bond premium is calculated, you need to decide how the bond premium shall be amortized. There are two methods for the same, which are discussed below. Based on your chosen method, you can amortize the bond premium in the books of accounts. The amount amortized each month must be booked as an expense.
Methods of Amortization of Bond Premium
There are two methods of it:
1. Straight Line Method
Under this method, the amount of bond premium is equally amortized each year or accounting period. The amortization amount is calculated by dividing the value of the amortization premium by its life. Accordingly, an equal amount of bond premium is amortized each year. Typically companies make an amortization table for the amortization of bond premiums each year.
Bond Premium Amortization Amount = Bond Premium ÷ Bond Life
2. Effective Interest Rate Method
This method relates the interest expense for the period to the bond’s book value. The amount of interest decreases with a decrease in the bond’s book value. This method is considered a more practical method.
Bond Premium Amortization Amount = Issue Price × Market Interest Rate – Face Value × Coupon Rate.
Examples of Amortization of Bond Premium (With Excel Template)
Let’s take an example to understand the calculation of it in a better manner.
Example #1
Suppose the company issues 2000 bonds for $ 22,800 each, and the face value of the bonds is $ 20,000. The bonds are to be redeemed after a period of 10 years at face value. The coupon rate of bonds is 10%, and the market rate of interest stands at 8%.
Solution:
The bond Premium is calculated using the formula given below:
Bond Premium = (Issue Price – Face Value) × No. of Bonds Issued
- Bond Premium = ($22,800 – $20,000) × 2,000
- Bond Premium = $5,600,000
Now, let us calculate bond amortization using both methods.
Straight Line Method:
It is calculated using the formula given below:
Bond Premium Amortization Amount = Bond Premium ÷ Bond Life
- Bond Premium Amortization Amount = $5,600,000 ÷ 10
- Bond Premium Amortization Amount = $560,000
Thus, the bond premium to be amortized yearly under this method comes to $560,000. The exact amount will be amortized each year for ten years.
Example #2
Let us consider the below details regarding the issue of a bond:
- Bond Face Value: $2,50,000
- Bond Issue Price: $2,59,075
- Coupon Rate: 5%
- Market Interest Rate: 4%
- Bond Tenure: 4 Years
Solution:
Effective Interest Rate Method
The bond Premium is calculated using the formula given below:
Bond Premium = Issue Price – Face Value
- Bond Premium = $259,075 – $250,000
- Bond Premium = $9,075
The Bond Premium Amortization Amount is calculated using the formula given below:
Bond Premium Amortization Amount = Issue Price × Market Interest Rate – Face Value × Coupon Rate
Let us make the amortization table.
| Year | Opening Amortized Cost (A) |
Interest Payment (Face Value × Coupon Rate) (B) |
Interest Expense (A× Market Interest Rate) (C) |
Amortization of Bond Premium (C-B) (D) |
Closing Amortized Cost (A+D) (E) |
| 1 | 2,59,075 | 12,500 | 10,363 | -2,137 | 2,56,938 |
| 2 | 2,56,938 | 12,500 | 10,278 | -2,222 | 2,54,716 |
| 3 | 2,54,716 | 12,500 | 10,189 | -2,311 | 2,52,404 |
| 4 | 2,52,404 | 12,500 | 10,096 | -2,404 | 2,50,000 |
| TOTAL | -9,075 |
Advantages
Some of the significant advantages are as follows:
- The amount of amortized Premium is a tax-deductible expense.
- It reduces the cost basis of the taxable bond every year.
Conclusion
It helps the issuer write off the same interest expense over the bond’s life and claim tax benefits. For the investor, the bond premium forms part of the cost of the bond. The effective interest rate method is commonly used for bond premiums amortization.
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