Journal entry for amortization of bond discount and premium
Introduction
In accounting, we may issue a bond at a discount or at a premium which results in the carrying value of the bonds payable recorded on the balance sheet being lower or higher than the face value of the bond. In this case, we need to amortize the bond discount or bond premium in order to have the carrying value of the bonds payable equal its face value as well as to record the interest expense (debit or credit) to the income statement over the life of the bond.
And the amortization can be done through the straight-line method if the amount of bond discount or bond premium is immaterial. On the other hand, if the discount or premium amount is material or significant to financial statements, we need to amortize it through the effective interest rate method.
The effective interest rate method is more complicated than the straight-line method as in the straight-line method, we simply need to divide the discount or premium amount by the life of the bond. On the other hand, the effective interest rate method will require us to determine the discounted future cash flow of the bond before calculating the rate to apply to the carrying value of bonds payable.
Of course, we can use some tools to calculate the effective interest rate such as the excel spreadsheet where we can calculate the effective interest rate using the IRR() formula. In any case, we still need to make the journal entry for amortization of bond discount or bond premium in order to make the carrying value of the bonds payable equal to the face value of the bond at the end of the bond maturity.
This is because the carrying value of bonds payable equal bonds payable minus bonds discount or the bonds payable plus bond premium. Hence, once the balance of bond discount or bond premium becomes zero, the carrying value of the bonds payable will equal the balance of bonds payable itself which is the face value of the bonds. In other words, we amortize the bond discount or bond premium to eliminate the discount or premium amount of the issued bond by transferring it to the interest expense account.
Journal entry for amortization of bond discount
When we issue the bond at a discount, we will debit the cash account and the bond discount account while crediting the bonds payable account.
Issuing bonds at a discount:
| Account | Debit | Credit |
|---|---|---|
| Cash | xxxx | |
| Bond discount | xxxx | |
| Bonds payable | xxxx |
Likewise, the bond discount in this journal entry is the difference between the cash we receive and the face value of the bond we issue. And the normal balance of the bond discount is on the debit side as it is a contra account to the bonds payable.
In this case, the carrying value of the bonds payable on the balance sheet will equal bonds payable minus the bond discount.
| Carrying value of bonds payable on the balance sheet | |
| Bonds payable | xxxx |
| Less: Bond discount | (xxxx) |
| Carrying value of bonds payable | xxxx |
Hence, we need to make the amortization of the bond discount in order to have the carrying value of bonds payable equaling the face value of the bond at the end of the bond maturity.
Likewise, we can make the journal entry for the amortization of bond discount by debiting the interest expense account and crediting the bond discount account.
Amortization of bond discount:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | xxxx | |
| Bond discount | xxxx |
Journal entry for amortization of bond premium
On the other hand, when we issue the bond at a premium, we will debit the cash account and credit the bonds payable account and the bond premium account.
Issuing bonds at a premium:
| Account | Debit | Credit |
|---|---|---|
| Cash | xxxx | |
| Bonds payable | xxxx | |
| Bond premium | xxxx |
The bond premium account in this journal entry is an additional amount to the bonds payable on the balance sheet. Likewise, its normal balance is on the credit side which is the same as the normal balance of the bonds payable account.
Hence, the carrying value of the bonds payable equals the bonds payable plus bond premium.
| Carrying value of bonds payable on the balance sheet | |
| Bonds payable | xxxx |
| Add: Bond premium | xxxx |
| Carrying value of bonds payable | xxxx |
In this case, we can make the journal entry for the amortization of bond premium by debiting the bond premium account and crediting the interest expense account.
Amortization of bond premium:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | xxxx | |
| Interest expense | xxxx |
This journal entry will reduce the interest expense on the income statement that we record at the time of interest payment.
Example for amortization of bond discount and premium
For example, we issue $500,000, three-year, 6% bonds for only $485,000. The interest is payable annually at the end of each year.
What is the journal entry for issuing bond at a discount and the amortization of bond discount using:
- using the straight-line method
- using the effective interest rate method
What is the difference between the bond discount amortization using the straight-line method and the bond discount amortization using the effective interest rate method?
Solution:
Issuing bonds at a discount
We can make the journal entry for issuing the $500,000 bonds at a discount by debiting the $485,000 to the cash account and the $15,000 of the difference to the bond discount account while crediting the bonds payable account with the $500,000 amount as below:
| Account | Debit | Credit |
|---|---|---|
| Cash | 485,000 | |
| Bond discount | 15,000 | |
| Bonds payable | 500,000 |
In this journal entry, the carrying value of the bonds payable on the balance sheet is $485,000 as the $15,000 bond discount is a contra account to the $500,000 bonds payable.
| Carrying value of bonds payable on the balance sheet | |
| Bonds payable | $500,000 |
| Less: Bond discount | (15,000) |
| Carrying value of bonds payable | $485,000 |
Amortization of bond discount using straight-line
The $15,000 bond discount above will need to be amortized each year so that the carrying value of the bonds payable equals $500,000 at the end of the maturity of the bonds.
Using the straight-line method, we can amortize the $15,000 bond discount by dividing it by the 3 years life of the bonds which gives the result of $5,000 per year.
In this case, we can make the journal entry for amortization of the $15,000 bond discount for each year as below:
Year 1:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Bond discount | 5,000 |
Year 2:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Bond discount | 5,000 |
Year 3:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,000 | |
| Bond discount | 5,000 |
At the end of the 3rd year, the $15,000 bond discount will be become zero ($15,000 – $5,000 – $5,000 – $5,000) and the carrying value of the bonds payable will equal $500,000 ($500,000 – $0).
Amortization of bond discount using effective interest rate
Under the effective interest rate method, we need to determine the effective interest rate using the cash flow provided by the bonds throughout the periods.
And from the information of the $500,000 bonds issued above, we can generate a schedule of cash flow of the bonds as below:
| Year | Amount |
| 0 | 485,000 |
| 1 | (30,000) |
| 2 | (30,000) |
| 3 | (530,000) |
In this case, we can calculate the effective interest rate to be 7.1462% per annum using the excel formula of IRR(). (Detail working in excel spreadsheet can be found in the link here: Amortization of bond discount and premium)
Hence, we can generate the detail of three-year discounted bonds as below:
| Year | Bonds Payable | Premium | Carrying Value | Interest payment | Interest expense | Premium amortized |
|---|---|---|---|---|---|---|
| 0 | 500,000 | 15,000 | 485,000 | – | – | – |
| 1 | 500,000 | 10,341 | 489,659 | 30,000 | 34,659 | 4,659 |
| 2 | 500,000 | 5,349 | 494,651 | 30,000 | 34,992 | 4,992 |
| 3 | 500,000 | (0) | 500,000 | 30,000 | 35,349 | 5,349 |
| Total | 90,000 | 105,000 | 15,000 |
**Interest expense = Carrying value of bonds payable at the beginning of the year x effective interest rate
Likewise, we can make the journal entry for the amortization of the bond discount using the effective interest rate method for each year as below:
Year 1:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 4,659 | |
| Bond discount | 4,659 |
Year 2:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 4,992 | |
| Bond discount | 4,992 |
Year 3:
| Account | Debit | Credit |
|---|---|---|
| Interest expense | 5,349 | |
| Bond discount | 5,349 |
As a result, we can see that there is a small difference between the amortization of bond discount using the straight-line method and the one using the effective interest rate method.
| Amortization of bond discount | |||
|---|---|---|---|
| Year | Straight-line | Effective interest rate | Difference |
| 1 | 5,000 | 4,659 | 341 |
| 2 | 5,000 | 4,992 | 8 |
| 3 | 5,000 | 5,349 | (349) |
Example 2: Bond premium
For example, we issue $500,000, three-year, 6% bonds for $512,000 instead. We need to pay interest at the end of each year during the period of the bonds.
What is the journal entry for issuing bonds at a premium?
What is the journal entry for amortization of bond premium using the straight-line method and the effective interest rate method?
Solution:
Issuing of bonds at a premium
We can make the journal entry for issuing of bonds at a premium by debiting the $512,000 to the cash account and crediting the $500,000 to the bonds payable account and the $12,000 difference to the bond premium account as below:
| Account | Debit | Credit |
|---|---|---|
| Cash | 512,000 | |
| Bonds payable | 500,000 | |
| Bond premium | 12,000 |
Likewise, the carrying value of the bonds payable on the balance sheet is $512,000 since the $12,000 bond premium is an additional amount to the $500,000 bonds payable.
| Carrying value of bonds payable on the balance sheet | |
| Bonds payable | $500,000 |
| Add: Bond premium | 12,000 |
| Carrying value of bonds payable | $512,000 |
Amortization of bond premium using straight-line method
Using the straight-line method, we can amortize the $12,000 bond premium to be $4,000 per year for each of the three years of bond periods.
In this case, we can make the journal entry for amortization of bond premium using the straight-line method for each year as below:
Year 1:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 4,000 | |
| Interest expense | 4,000 |
Year 2:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 4,000 | |
| Interest expense | 4,000 |
Year 3:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 4,000 | |
| Interest expense | 4,000 |
Likewise, at the end of the maturity of the bond, the $12,000 of the bond premium will become zero.
Amortization of bond premium using effective interest rate method
With the information above, we can generate the schedule of the cash flow for the $500,000 bonds as below:
| Year | Amount |
| 0 | 512,000 |
| 1 | (30,000) |
| 2 | (30,000) |
| 3 | (530,000) |
In this case, we can calculate the effective interest rate to be 5.1168% per year using the “IRR()” excel formula. (Detail working in excel spreadsheet can be found in the link here: Amortization of bond discount and premium)
Hence, we can generate the schedule of bond payment and other accounting information as in the table below:
| Year | Bonds Payable | Premium | Carrying Value | Interest payment | Interest expense | Premium amortized |
|---|---|---|---|---|---|---|
| 0 | 500,000 | 12,000 | 512,000 | – | – | – |
| 1 | 500,000 | 8,198 | 508,198 | 30,000 | 26,198 | 3,802 |
| 2 | 500,000 | 4,201 | 504,201 | 30,000 | 26,003 | 3,997 |
| 3 | 500,000 | 0 | 500,000 | 30,000 | 25,799 | 4,201 |
| Total | 90,000 | 78,000 | 12,000 |
***Interest expense = Carrying value of bonds payable at the beginning of the year x effective interest rate
So, we can make the journal entry for the amortization of the bond premium using the effective interest rate for each year of the three years as below:
Year 1:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 3,802 | |
| Interest expense | 3,802 |
Year 2:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 3,997 | |
| Interest expense | 3,997 |
Year 3:
| Account | Debit | Credit |
|---|---|---|
| Bond premium | 4,201 | |
| Interest expense | 4,201 |
Likewise, at the end of the third year, the $12,000 balance of the bond premium account will become zero ($12,000 – $3,802 – $3,997 – $4,201), and the carrying value of bonds payable will equal their face value of $500,000.
And when we redeem the $500,000 bonds back at the end of their maturity, we can reduce the carrying value of bonds payable to zero by simply debiting the bonds payable account and crediting the cash account.
| Account | Debit | Credit |
|---|---|---|
| Bonds payable | 500,000 | |
| Cash | 500,000 |
