This $32,400 return on an investment of $67,600 gives the investor an 8% annual law firm chart of accounts return compounded semiannually. 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.

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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, 2023 to $100,000 when the bonds mature on December 31, 2027. Reducing the bond premium in a logical and systematic manner is referred to as amortization. Throughout our explanation of bonds payable we will use the term stated interest rate or stated rate.

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The effective interest method is grounded in the principle of allocating interest expense over the life of a bond in a manner that reflects the constant rate of return on the book value of the bond. This approach contrasts with simpler methods by ensuring that the interest expense recognized in each period is proportional to the carrying amount of the bond at the beginning of the period. This proportionality is achieved by applying the bond’s effective interest rate to its carrying amount, which includes any premium or discount at issuance. For floating-rate instruments, periodic re-estimation of cash flows affects EIR without causing a one-time gain or loss in P/L.

Amortization Under Effective Interest Method

• The present value of a bond is calculated by discounting the bond’s future cash payments by the current market interest rate.
• The bond is dated January 1, 2023 and requires interest payments on each June 30 and December 31 until the bond matures at the end of 5 years.
• The $10,000 difference between the sales price and the face value of the bond must be amortized over 10 years.
• In the case of a bond, since “n” refers to the number of semiannual interest periods, you select the column with the market interest rate per semiannual period.
• However, the difference between how much it has to ultimately repay in principal ($100,000) and the amount it received from selling the bonds ($95,000) represents an additional cost of financing.
• They use this to take into consideration the accretion of a bond discount as you move the balance into interest income.

Holders of common stock elect the corporation’s directors and share in the distribution of profits of the company via dividends. If the corporation were to liquidate, the secured lenders would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders. Such bonds were known as bearer bonds and the bonds had coupons attached that the bearer would “clip” and deposit at the bearer’s bank. The bond’s total present value of $104,100 should approximate the bond’s market value.

• It is reasonable that a bond promising to pay 9% interest will sell for less than its face value when the market is expecting to earn 10% interest.
• This annual amortization amount is the discount on the bonds ($10,000) divided by the 10-year life of the bond, or $1,000 per year.
• The amount of amortization is the difference between the cash paid for interest and the calculated amount of bond interest expense.
• Put another way, the effective interest rate is equal to the nominal return relative to the actual principal investment.
• In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price.

What is the difference between nominal rate and effective rate?

• The bond amortization calculator calculates the bond issue price, which is a function of both the bond rate and the market rate.
• You can find the amount of discount amortization by taking the interest expense we calculated ($9,385.54) and subtracting the cash interest ($9,000), resulting in $385.54 of discount amortization in year one.
• Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting.
• Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases.
• When a bond fluctuates in price from its par value, it impacts the actual interest rate paid by the bond, known as the effective interest rate.

Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline. A financial instrument issued at par means the buyer has paid the exact value for the financial instruments. Since carrying the value bookkeeping of the bond is exactly equal to the par value of the bond, the effective interest method is not applicable. Normal journal entries will be passed on the issuance of bonds, accrual, and payment of interest, payment of principal amount at maturity. This bond amortization calculator can be used for any bond up to a maximum term of 200 interest payment periods.

Bond Principal Payment

The final bond accounting journal would be to repay the par value of the bond with cash. The effective interest amortization method calculator initial carrying amount is less than the face value, and the effective interest rate is higher than the nominal rate. As interest is accrued, the carrying amount increases due to the amortization of the discount.