Amortization schedules, bonds payable, bond calculation methods, and more.
|What is amortization of a bond?|
|Are bonds payable amortized?|
|How to calculate bond amortization|
|What is a sinking fund?|
|Managing amortization of bonds|
Do you have clients looking to issue bonds? Bonds are generally thought to be lower risk than stocks, which makes them a popular choice among many investors. And for companies issuing a bond, bond amortization can prove to be considerably beneficial.
A bond, which is a limited-life intangible asset, is essentially a loan agreement between the issuer of the bond (i.e., corporation, government, or municipality) and the bond holder.
For risk-adverse investors, bonds can be an attractive way to receive an anticipated return and safeguard capital. For issuers, bonds can be a way to provide operating cash flow, fund capital investments, and finance debt.
Enter amortized bonds. Amortized bonds differ from other types of loans and helping clients better understand bond amortization can further strengthen your role as a trusted advisor.
In this article, we’ll explore what bond amortization means, how to calculate it, and more.
What is amortization of a bond?
When a bond is amortized, the principal amount, also known as the face value, and the interest due are gradually paid down until the bond reaches maturity.
Using an amortization schedule, the bond’s principal is divided up and paid off incrementally, usually in monthly installments. For instance, if the bond matures after 30 years, then the bond’s face value, plus interest, is paid off in monthly payments. Typically, the calculations are done in such a way that each amortized bond payment is the same amount.
An easy way to think of it is like a mortgage for a house. In this case, the bond holder essentially assumes the same role as a bank lending a 30-year mortgage to a home buyer. Much like the bank receiving regular payments over the life of the mortgage loan, the bond holder receives regular payments of both principal and interest until the bond reaches maturity.
What are the benefits of bond amortization?
For those issuing the bond, amortization is an accounting tactic that has beneficial tax implications. Accountants can treat the bond like an amortized asset.
If the issuer lets the buyer purchase the bond for less than face value, the issuer can document the bond discount like an asset for the entirety of the bond’s life.
The amortized bond’s discount is shown on the income statement as a portion of the issuer’s interest expense. Interest expenses, which are non-operating costs, help businesses reduce earnings before tax (EBT) expenses.
For investors, there can be tax implications for the amortization of bond premiums or discounts. Bond premiums may be tax deductible in some situations. On the other hand, bond discounts may be taxed as ordinary income.
It should also be noted that, depending on the issuer, amortized bonds can be tax-exempt or taxable. There are strategies that can be leveraged to optimize the tax efficiency of an investor’s bond portfolios, such as investing in tax-exempt bonds.
The trusted guidebook to critical tax questions from Thomson Reuters Checkpoint®
Are bonds payable amortized?
The short answer is yes. When a company issues bonds to generate cash, bonds payable are recorded and listed as a liability on the company’s balance sheet. Typically, they fall under non-current class of liabilities.
Bonds can be issued at face value, or at a discount or premium. If a bond is issued at a discount or premium, the amount will be amortized over the years until the bond matures.
Accountants can create an amortization schedule for the bonds payable. This will detail the discount or premium and outline the changes to it each period that coupon payments (the dollar amount of interest paid to an investor) are due.
What does it mean to amortize a bond discount or premium?
If the stated interest rate on a bond is less than the market interest rate, it is not uncommon for an investor to pay less than the face value of the bond. In this instance, the difference between the face value and the amount paid is placed in a contra liability account, and the amount of the reduced payment is amortized over the term of the bond. This is known as the amortization of a bond discount.
The end result: over the life of the bond, the total recognized amount of interest expense outweighs the amount of interest actually paid to investors.
Discount amortizations must be carefully documented as they are likely to be reviewed by auditors. The effective-interest method to amortize the discount on bonds payable is often preferred by auditors because of the clarity the method provides.
Now, let’s look at the amortization of premium on bonds payable. In this case, the investor pays more than the face value of a bond when the stated interest rate is greater than the market interest rate. If this happens, the issuer amortizes the excess payment over the life of the bond. This lowers the amount charged to interest expense.
How do you calculate bond amortization?
The straight-line and effective-interest methods are two common ways to calculate amortization.
The straight-line method is a linear method that is the simplest to use. Using the straight-line method, bond amortization results in bond discount amortization values that are equal throughout the term of the bond.
This is the method typically used for bonds sold at a discount or premium. And, as noted earlier, it is often auditors’ preferred method to amortize the discount on bonds payable. This method determines the different amortization amounts that need to be applied to each interest expenditure within each calculation period.
What is a sinking fund?
A sinking fund is a type of fund set up to pay back debt. Bond issuers may use sinking funds to buy back issued bonds or parts of bonds prior to the maturity date of the bond.
Sinking funds help attract investors and assure them that the bond issuer will not default on their payments. By establishing a sinking fund, the issuer is taking steps to ensure there is enough money available to repay the debt.
Managing amortization of bonds
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