Fund Accounting

Bond Amortization Methods & Journal Entries

 Bond Amortization Methodologies

1. Bond Premium with Straight-Line Amortization

When a corporation prepares to issue/sell a bond to investors, the corporation might anticipate that the
appropriate interest rate will be 9%. If the investors are willing to accept the 9% interest rate, the bond will
sell for its face value. If however, the market interest rate is less than 9% when the bond is issued, the
corporation will receive more than the face amount of the bond. The amount received for the bond
(excluding accrued interest) that is in excess of the bond’s face amount is known as the premium on
bonds payable, bond premium, or premium.

To illustrate the premium on bonds payable, let's assume that in early December 2009, a corporation has
prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). The bond is dated
as of January 1, 2010 and has a maturity date of December 31, 2014. The bond's interest payment dates
are June 30 and December 31 of each year. This means that the corporation will be required to make
semiannual interest payments of $4,500 ($100,000 x 9% x 6/12).

Let's assume that just prior to selling the bond on January 1, the market interest rate for this bond drops
to 8%. Rather than changing the bond's stated interest rate to 8%, the corporation proceeds to issue the
9% bond on January 1, 2010. Since this 9% bond will be sold when the market interest rate is 8%, the
corporation will receive more than the bond’s face value.

Let’s assume that this 9% bond being issued in an 8% market will sell for $104,100 plus $0 accrued
interest. The corporation’s journal entry to record the issuance of the bond on January 1, 2010 will be:

Jan. 1, 2010 Cash 104,100

Bonds Payable 100,000
Premium on Bonds Payable 4,100

The account Premium on Bonds Payable is a liability account that will always appear on the balance
sheet with the account Bonds Payable. In other words, if the bonds are a long term liability, both Bonds
Payable and Premium on Bonds Payable will be reported on the balance sheet as long term liabilities.
The combination of these two accounts is known as the book value or carrying value of the bonds. On
January 1, 2010 the book value of this bond is $104,100 ($100,000 credit balance in Bonds Payable +
$4,100 credit balance in Premium on Bonds Payable).

Premium on Bonds Payable with Straight-Line Amortization

Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0.
In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life. By
reducing the bond premium to $0, the bond’s book value will be decreasing from $104,100 on January 1,
2010 to $100,000 when the bonds mature on December 31, 2014. Reducing the bond premium in a
logical and systematic manner is referred to as amortization.

The bond premium of $4,100 was received by the corporation because its interest payments to the
bondholders will be greater than the amount demanded by the market interest rates. Therefore, the
amortization of the bond premium will involve the account Interest Expense. Each accounting period
during the life of the bond there needs to be a credit to Interest Expense and a debit to Premium on
Bonds Payable.

Straight-Line Amortization of Bond Premium on Annual Financial Statements

If a corporation issues only annual financial statements and its accounting year ends on December 31,
the amortization of the bond premium can be recorded once each year. In the case of the 9% $100,000
bond issued for $104,100 and maturing in 5 years, the annual straight-line amortization of the bond
premium will be $820 ($4,100 divided by 5 years).

However, when a corporation issues only annual financial statements, the amortization of the bond
premium is often recorded at the time of its semiannual interest payments. Under this assumption the
journal entries on June 30 and December 31 will be:
Interest Expense 4,090
Jun 30, 2010
Premium on Bonds Payable 410
Cash 4,500

Dec 31, 2010 Interest Expense 4,090

Premium on Bonds Payable 410
Cash 4,500
The combination of the interest payments and the bond amortization results in the net amount of $8,180
($4,500 of interest paid on June 30 + $4,500 of interest paid on December 31 minus $410 of amortization
on June 30 and minus $410 of amortization on December 31). This $8,180 will be reported in the account
Interest Expense for the year 2010 as shown in the following T-account:

Interest Expense
Jun 30, 2010 pmt minus amort 4,090
Dec 31, 2010 pmt minus amort 4,090
Dec 31, 2010 balance 8,180
The following T-account shows how the balance in the account Premium on Bonds Payable will decrease
over the 5-year life of the bonds under the straight-line method of amortization.

Premium On Payable Bonds

4,100 Jan 1, 2010 bond issued
Jun 30, 2010 amortization 410
Dec 31, 2010 amortization 410
3,280 Dec 31, 2010 balance
Jun 30, 2011 amortization 410
Dec 31, 2011 amortization 410
2,460 Dec 31, 2011 balance
Jun 30, 2012 amortization 410
Dec 31, 2012 amortization 410
1,640 Dec 31, 2012 balance
Jun 30, 2013 amortization 410
Dec 31, 2013 amortization 410
820 Dec 31, 2013 balance
Jun 30, 2014 amortization 410
Dec 31, 2014 amortization 410
 0 Dec 31, 2014 balance
The following table shows how the bond's book value will decrease from $104,100 to the bond’s maturity
amount of $100,000:

Credit Balance in Bonds Credit Balance in Bond Book Value of the

Date
Payable Account Premium Account Bond
Jan 1, 2010 $ 100,000 $ 4,100 $ 104,100
Dec 31, 2010 $ 100,000 $ 3,280 $ 103,280
Dec 31, 2011 $ 100,000 $ 2,460 $ 102,460
Dec 31, 2012 $ 100,000 $ 1,640 $ 101,640
Dec 31, 2013 $ 100,000 $ 820 $ 100,820
Dec 31, 2014 prior to
$ 100,000 $ 0 $ 100,000
paying $100,000

2. Amortizing Bond Premium with the Effective Interest Rate Method

When a bond is sold at a premium, the amount of the bond premium must be amortized to interest
expense over the life of the bond. In other words, the credit balance in the account Premium on Bonds
Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the
accounting periods that the bond is outstanding.

The preferred method for amortizing the bond premium is the effective interest rate method or the
effective interest method. Under the effective interest rate method the amount of interest expense in a
given year will correlate with the amount of the bond’s book value. This means that when a bond’s book
value decreases, the amount of interest expense will decrease. In short, the effective interest rate method
is more logical than the straight-line method of amortizing bond premium.

Before we demonstrate the effective interest rate method for amortizing the bond premium pertaining to a
5-year 9% $100,000 bond issued in an 8% market for $104,100 on January 1, 2010, let's outline a few
concepts:

1. The bond premium of $4,100 must be amortized to Interest Expense over the life of the bond.
This amortization will cause the bond’s book value to decrease from $104,100 on January 1,
2010 to $100,000 just prior to the bond maturing on December 31, 2014.

2. The corporation must make an interest payment of $4,500 ($100,000 x 9% x 6/12) on each June
30 and December 31. This means that the Cash account will be credited for $4,500 on each
interest payment date.

3. The effective interest rate method uses the market interest rate at the time that the bond was
issued. In our example, the market interest rate on January 1, 2010 was 4% per semiannual
period for 10 semiannual periods.

4. The effective interest rate is multiplied times the bond’s book value at the start of the accounting
period to arrive at each period’s interest expense.

5. The difference between Item 2 and Item 4 is the amount of amortization.

The following table illustrates the effective interest rate method of amortizing the $4,100 premium on a
corporation’s bonds payable:

A B C D E F G
Interest Interest
Amortization Balance Balance
Payment Expense Book Value of
Of Bond In Bond In Bonds
Date Stated Mkt 4% x the Bonds F
Premium Premium Payable
4.5% x Previous BV plus E
C minus B Account Account
Face in G
Debit Debit
Credit
Interest Bond
Cash
Expense Premium
Jan 1, 2010 $ 4,100 $ 100,000 $ 104,100
Jun 30, 2010 $ 4,500 $ 4,164 $ (336) $ 3,764 $ 100,000 $ 103,764
Dec 31, 2010 $ 4,500 $ 4,151 $ (349) $ 3,415 $ 100,000 $ 103,415
Jun 30, 2011 $ 4,500 $ 4,137 $ (363) $ 3,052 $ 100,000 $ 103,052
Dec 31, 2011 $ 4,500 $ 4,122 $ (378) $ 2,674 $ 100,000 $ 102,674
Jun 30, 2012 $ 4,500 $ 4,107 $ (393) $ 2,281 $ 100,000 $ 102,281
Dec 31, 2012 $ 4,500 $ 4,091 $ (409) $ 1,872 $ 100,000 $ 101,872
Jun 30, 2013 $ 4,500 $ 4,075 $ (425) $ 1,447 $ 100,000 $ 101,447
Dec 31, 2013 $ 4,500 $ 4,058 $ (442) $ 1,005 $ 100,000 $ 101,005
Jun 30, 2014 $ 4,500 $ 4,040 $ (460) $ 545 $ 100,000 $ 100,545
Dec 31, 2014 $ 4,500 $ 3,955 $ (545) $ 0 $ 100,000 $ 100,000
Totals $ 45,000 $ 40,900 $ ( 4,100)

Please make note of the following points:

• Column B shows the interest payments required in the bond contract: The bond’s stated rate
of 9% per year divided by two semiannual periods = 4.5% per semiannual period times the
face amount of the bond
• Column C shows the interest expense. This calculation uses the market interest rate at the
time the bond was issued: The market rate of 8% per year divided by two semiannual periods
= 4% semiannually.
• The interest expense in column C is the product of the 4% market interest rate per
semiannual period times the book value of the bond at the start of the semiannual period.
Notice how the interest expense is decreasing with the decrease in the book value in column
G. This correlation between the interest expense and the bond’s book value makes the
effective interest rate method the preferred method.
• Because the present value factors that we used were rounded to three decimal places, our
calculations are not as precise as the amounts determined by use of computer software, a
financial calculator, or factors with more decimal places. As a result, the amounts in year
2014 required a small adjustment.
If the company issues only annual financial statements and its accounting year ends on December 31,
the amortization of the bond premium can be recorded at the interest payment dates by using the
amounts from the schedule above. In our example there was no accrued interest at the issue date of the
bonds and there is no accrued interest at the end of each accounting year because the bonds pay
interest on June 30 and December 31. The entries for 2010, including the entry to record the bond
issuance, are:

Jan 1, 2010 Cash 104,100

Bonds Payable 100,000
Premium on Bonds Payable 4,100

Jun 30, 2010 Interest Expense 4,164

Premium on Bonds Payable 336
Cash 4,500

Dec 31, 2010 Interest Expense 4,151

Premium on Bonds Payable 349
Cash 4,500

The journal entries for the year 2011 are:

Jun 30, 2011 Interest Expense 4,137

Premium on Bonds Payable 363
Cash 4,500

Dec 31, 2011 Interest Expense 4,122

Premium on Bonds Payable 378
Cash 4,500

The journal entries for 2012, 2013, and 2014 will also be taken from the schedule above.

Comparison of Amortization Methods

Below is a comparison of the amount of interest expense reported under the effective interest rate
method and the straight-line method. Note that under the effective interest rate method the interest
expense for each year is decreasing as the book value of the bond decreases. Under the straight-line
method the interest expense remains at a constant annual amount even though the book value of the
bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the
straight-line method when the amount of bond premium is not significant.
 Effective Interest Rate Method Straight-Line Method
Interest Book Value at Interest Book Value at
Year
Expense Beg. of Year Expense Beg. of Year
2010 $ 8,315 $ 104,100 $ 8,180 $ 104,100
2011 $ 8,259 $ 103,415 $ 8,180 $ 103,280
2012 $ 8,198 $ 102,674 $ 8,180 $ 102,460
2013 $ 8,133 $ 101,872 $ 8,180 $ 101,640
2014 $ 7,995 $ 101,005 $ 8,180 $ 100,820
Totals $ 40,900 $ 40,900

Notice that under both methods of amortization, the book value at the time the bonds were issued
($104,100) moves toward the bond's maturity value of $100,000. The reason is that the bond premium of
$4,100 is being amortized to interest expense over the life of the bond.

Also notice that under both methods the corporation's total interest expense over the life of the bond will
be $40,900 ($45,000 of interest payments minus the $4,100 of premium received from the purchasers of
the bond when it was issued.)

3. Bond Discount with Straight-Line Amortization

When a corporation is preparing a bond to be issued/sold to investors, it may have to anticipate the
interest rate to appear on the face of the bond and in its legal contract. Let’s assume that the corporation
prepares a $100,000 bond with an interest rate of 9%. Just prior to issuing the bond, a financial crisis
occurs and the market interest rate for this type of bond increases to 10%. If the corporation goes forward
and sells its 9% bond in the 10% market, it will receive less than $100,000. When a bond is sold for less
than its face amount, it is said to have been sold at a discount. The discount is the difference between the
amount received (excluding accrued interest) and the bond’s face amount. The difference is known by the
terms discount on bonds payable, bond discount, or discount.

To illustrate the discount on bonds payable, let’s assume that in early December 2009 a corporation
prepares a 9% $100,000 bond dated January 1, 2010. The interest payments of $4,500 ($100,000 x 9% x
6/12) will be required on each June 30 and December 31 until the bond matures on December 31, 2014.

Next, let's assume that just prior to offering the bond to investors on January 1, the market interest rate
for this bond increases to 10%. The corporation decides to sell the 9% bond rather than changing the
bond documents to the market interest rate. Since the corporation is selling its 9% bond in a bond market
which is demanding 10%, the corporation will receive less than the bond’s face amount.

To illustrate the accounting for bonds payable issued at a discount, let’s assume that the 9% bond is sold
in the 10% market for $96,149 plus $0 accrued interest on January 1, 2010. The corporation's journal
entry to record the sale of the bond will be:

Jan. 1, 2010 Cash 96,149

Discount on Bonds Payable 3,851
 Bonds Payable 100,000
The account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra
liability account since it will have a debit balance. Discount on Bonds Payable will always appear on the
balance sheet with the account Bonds Payable. In other words, if the bond is a long term liability, both
Bonds Payable and Discount on Bonds Payable will be reported on the balance sheet as long term
liabilities. The combination or net of these two accounts is known as the book value or the carrying
value of the bonds. On January 1, 2010 the book value of this bond is $96,149 (the $100,000 credit
balance in Bonds Payable minus the debit balance of $3,851 in Discount on Bonds Payable.)

Discount on Bonds Payable with Straight-Line Amortization

Over the life of the bond, the balance in the account Discount on Bonds Payable must be reduced to $0.
Reducing this account balance in a logical manner is known as amortizing or amortization. Since a
bond's discount is caused by the difference between a bond's stated interest rate and the market interest
rate, the journal entry for amortizing the discount will involve the account Interest Expense.

In our example, the bond discount of $3,851 results from the corporation receiving only $96,149 from
investors, but having to pay the investors $100,000 on the date that the bond matures. The discount of
$3,851 is treated as an additional interest expense over the life of the bonds. When the same amount of
bond discount is recorded each year, it is referred to as straight-line amortization. In this example, the
straight-line amortization would be $770.20 ($3,851 divided by the 5-year life of the bond).

Straight-Line Amortization of Bond Discount on Annual Financial Statements

If a corporation issues only annual financial statements on December 31, the amortization of bond
discount is often recorded at the time of its semiannual interest payments. In our example the journal
entries for 2010 under the straight-line method will be:

Jun 30, 2010 Interest Expense 4,885

Discount on Bonds Payable 385
Interest Payable 4,500

Dec 31, 2010 Interest Expense 4,885

Discount on Bonds Payable 385
Interest Payable
4,500

The interest expense for the year 2010 will be $9,770 (the two semiannual interest payments of $4,500
each plus the two semiannual amortizations of bond discount of $385 each). The following T-account for
Interest Expense shows the entries for the year 2010:

Interest Expense
Jun 30, 2010 pmt & amort 4,885
Dec 31, 2010 pmt & amort 4,885
Dec 31, 2010 balance 9,770
The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over
the 5-year life of the bond.

Discount on Bonds Payable

Jan 1, 2010 bond issued 3,851
385 Jun 30, 2010 amortization
385 Dec 31, 2010 amortization
Dec 31, 2010 balance 3,081
385 Jun 30, 2011 amortization
385 Dec 31, 2011 amortization
Dec 31, 2011 balance 2,311
385 Jun 30, 2012 amortization
385 Dec 31, 2012 amortization
Dec 31, 2012 balance 1,541
385 Jun 30, 2013 amortization
385 Dec 31, 2013 amortization
Dec 31, 2013 balance 771
385 Jun 30, 2014 amortization
386 Dec 31, 2014 amortization
Dec 31, 2014 balance 0

As the bond discount is amortized, the bond’s book value will be increasing from $96,149 on the date the
bond was issued to the bond’s maturity amount of $100,000:

Credit Balance in Bonds Debit Balance in Bond Book Value of the

Date
Payable Account Discount Account Bond
Jan 1, 2010 $ 100,000 $ 3,851 $ 96,149
Dec 31, 2010 $ 100,000 $ 3,081 $ 96,919
Dec 31, 2011 $ 100,000 $ 2,311 $ 97,689
Dec 31, 2012 $ 100,000 $ 1,541 $ 98,459
Dec 31, 2013 $ 100,000 $ 771 $ 99,229
Dec 31, 2014 prior to
$ 100,000 $ 0 $ 100,000
paying $100,000

4. Amortizing Bond Discount with the Effective Interest Rate Method

When a bond is sold at a discount, the amount of the bond discount must be amortized to interest
expense over the life of the bond. Since the debit amount in the account Discount on Bonds Payable will
be moved to the account Interest Expense, the amortization will cause each period’s interest expense to
be greater than the amount of interest paid during each of the years that the bond is outstanding.

The preferred method for amortizing the bond discount is the effective interest rate method or the
effective interest method. Under the effective interest rate method the amount of interest expense in a
given accounting period will correlate with the amount of a bond’s book value at the beginning of the
accounting period. This means that as a bond’s book value increases, the amount of interest expense will
increase.

Before we demonstrate the effective interest rate method for a 5-year 9% $100,000 bond issued in a 10%
market for $96,149, let's highlight a few points:

1. The bond discount of $3,851 must be amortized to Interest Expense over the life of the bond. The
amortization will cause the bond’s book value to increase from $96,149 on January 1, 2010 to
$100,000 just prior to the bond maturing on December 31, 2014.

2. The corporation must make an interest payment of $4,500 ($100,000 x 9% x 6/12) on each June
30 and December 31 that the bonds are outstanding. The Cash account will be credited for
$4,500 on each of these dates.

3. The effective interest rate is the market interest rate on the date that the bonds were issued. In
our example the market interest rate on January 1, 2010 was 5% per semiannual period for 10
semiannual periods.

4. The effective interest rate is multiplied times the bond’s book value at the start of the accounting
period to arrive at each period’s interest expense.

5. The difference between Item 2 and Item 4 is the amount of amortization.

The following table illustrates the effective interest rate method of amortizing the $3,851 discount on
bonds payable:

A B C D E F G
Interest Interest
Balance In Balance In Book Value
Payment Expense Amortization of
the Account the Account of the
Date Stated Mkt 5% x Bond Discount
Bond Bonds Bonds
4.5% x Previous BV C minus B
Discount Payable F minus E
Face in G
Debit Credit
Credit
Interest Bond
Cash
Expense Discount
Jan 1, 2010 $ 3,851 $ 100,000 $ 96,149
Jun 30, 2010 $ 4,500 $ 4,807 $ 307 $ 3,544 $ 100,000 $ 96,456
Dec 31, 2010 $ 4,500 $ 4,822 $ 322 $ 3,222 $ 100,000 $ 96,778
Jun 30, 2011 $ 4,500 $ 4,839 $ 339 $ 2,883 $ 100,000 $ 97,117
Dec 31, 2011 $ 4,500 $ 4,856 $ 356 $ 2,527 $ 100,000 $ 97,473
Jun 30, 2012 $ 4,500 $ 4,874 $ 374 $ 2,153 $ 100,000 $ 97,847
 Dec 31, 2012 $ 4,500 $ 4,892 $ 392 $ 1,761 $ 100,000 $ 98,239
Jun 30, 2013 $ 4,500 $ 4,912 $ 412 $ 1,349 $ 100,000 $ 98,651
Dec 31, 2013 $ 4,500 $ 4,933 $ 433 $ 916 $ 100,000 $ 99,084
Jun 30, 2014 $ 4,500 $ 4,954 $ 454 $ 462 $ 100,000 $ 99,538
Dec 31, 2014 $ 4,500 $ 4,962 $ 462 $ 0 $ 100,000 $ 100,000
Totals $ 45,000 $ 48,851 $ 3,851

Let’s make a few points about the above table:

• Column B shows the interest payments required by the bond contract: The bond’s stated rate
of 9% per year divided by two semiannual periods = 4.5% per semiannual period multiplied
times the face amount of the bond.
• Column C shows the interest expense. This calculation uses the market interest rate at the
time the bonds were issued: The market rate of 10% per year divided by two semiannual
periods = 5% semiannually.
• The interest expense in column C is the product of the 5% market interest rate per
semiannual period times the book value of the bond at the start of the semiannual period.
Notice how the interest expense is increasing with the increase in the book value in column
G. This correlation between the interest expense and the bond’s book value makes the
effective interest rate method the preferred method for amortizing the discount on bonds
payable.
• Because the present value factors that we used were rounded to three decimal positions, our
calculations are not as precise as the amounts determined by use of computer software, a
financial calculator, or factors that were carried out to more decimal places. As a result, our
amortization amount in 2014 required a slight adjustment.

If the company issues only annual financial statements and its accounting year ends on December 31,
the amortization of the bond discount can be recorded on the interest payment dates by using the
amounts from the schedule above. In our example, there is no accrued interest at the issue date of the
bonds and at the end of each accounting year because the bonds pay interest on June 30 and December
31. The entries for 2010, including the entry to record the bond issuance, are shown next.

Jan 1, 2010 Cash 96,149

Discount on Bonds Payable 3,851
Bonds Payable 100,000

Jun 30, 2010 Interest Expense 4,807

Discount on Bonds Payable 307
Cash 4,500

Interest Expense 4,822

Dec 31, 2010
Discount on Bonds Payable 322
Cash 4,500
The journal entries for the year 2011 are:

Jun 30, 2011 Interest Expense 4,839

Discount on Bonds Payable 339
Cash 4,500

Dec 31, 2011 Interest Expense 4,856

Discount on Bonds Payable 356
Cash 4,500

The journal entries for the years 2012 through 2014 will also be taken from the schedule shown above.

Comparison of Amortization Methods

Below is a comparison of the amount of interest expense reported under the effective interest rate
method and the straight-line method. Note that under the effective interest rate method the interest
expense for each year is increasing as the book value of the bond increases. Under the straight-line
method the interest expense remains at a constant amount even though the book value of the bond is
increasing. The accounting profession prefers the effective interest rate method, but allows the straight-
line method when the amount of bond discount is not significant.

Effective Interest Rate Method Straight-Line Method

Interest Book Value at Interest Book Value at
Year
Expense Beg. of Year Expense Beg. of Year
2010 $ 9,629 $ 96,149 $ 9,770 $ 96,149
2011 $ 9,695 $ 96,778 $ 9,770 $ 96,919
2012 $ 9,766 $ 97,473 $ 9,770 $ 97,689
2013 $ 9,845 $ 98,239 $ 9,770 $ 98,459
2014 $ 9,916 $ 99,084 $ 9,771 $ 99,229
Totals $ 48,851 $ 48,851

Notice that under both methods of amortization, the book value at the time the bonds were issued
($96,149) moves toward the bond’s maturity value of $100,000. The reason is that the bond discount of
$3,851 is being reduced to $0 as the bond discount is amortized to interest expense.

Also notice that under both methods the total interest expense over the life of the bonds is $48,851
($45,000 of interest payments plus the $3,851 of bond discount.)

Summary of the Effect of Market Interest Rates on a Bond’s Issue Price

The following table summarizes the effect of the change in the market interest rate on an existing
$100,000 bond with a stated interest rate of 9% and maturing in 5 years.
Bond’s Stated Interest Market Interest Issue Price of Bond
Bond Issued At
Rate per Year Rate per Year (Present Value)
9% 9% $100,000 Par
9% 8% $104,100 Premium
9% 10% $ 96,149 Discount