# Federal and Tri-State Area Income Tax Treatment of Amortizable Bond Premium

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The reality is that there are two major component of a bond that the FAR exam wants you to know about. Company DS issued 5-years 8%-annual coupon bonds with a face value of $100,000 for $92,420. Helstrom attended Southern Illinois University at Carbondale and has her Bachelor of Science in accounting.

- A serial bond is a bond issue that is structured so that a portion of the outstanding bonds mature at regular intervals until all of the bonds have matured.
- They ensure that the premium is repaid when the bond matures so that the payment stream is the one that was expected upon sale of the bond.
- After six months, you make the first interest payment of $45,000.The semi-annual interest expense is 4 percent of $1.041 million, or $41,640.
- C uses the cash receipts and disbursements method of accounting, and C decides to use annual accrual periods ending on January 15 of each year.
- Is an accounting technique to adjust bond premiums over the bond’s life.

Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services. For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond. Calculate the total amount of interest you’ll receive if you hold the bond until maturity. For example, if there are 10 payments left and the interest is $4,500 per payment, then the total value of the interest payments is $45,000 or $4,500 x 10. You need to know how much money you’ll receive with every interest during the life of the bond.

## Cost Accounting

The issue price and face value are equal only when market interest rate and the coupon rate are equal. Amortizable Bond Premium refers to the cost of premium paid above the face value of a bond. The face value of a bond is also called “par value”, it is the original cost of a stock or the amount paid to the holder of a bond. The remaining amounts of qualified stated interest and bond https://www.bookstime.com/ premium allocable to the accrual period ending on February 1, 2000, are taken into account for the taxable year ending on December 31, 2000. The second way to amortize the premium is with the effective interest method. The effective interest method is a more accurate method of amortization, but also calls for a more complicated calculation, since it changes in each accounting period.

- However, the straight-line method assumes that in each period throughout the bond’s life the value of the adjustment is the same.
- This $417 consists of 4 months’ cash interest plus $17 of the amortized discount.
- A subordinated debenture bond means the bond is repaid after other unsecured debt, as noted in the bond agreement.
- For example, if you pay $1,025 for a $1,000 maturity bond, your premium is $25.
- For federal income tax purposes, IRC § 171 disallows a deduction for tax-exempt bonds.
- The effective interest rate method uses the market interest rate at the time that the bond was issued.
- The corporation, however, must distinguish between interest payments and premium amortization on its account statements.

On May 1, 1999, C purchases for $130,000 a taxable bond maturing on May 1, 2006, with a stated principal amount of $100,000, payable at maturity. FASB made targeted changes Thursday to the rules governing accounting for amortization of premiums for purchased callable debt securities.

## Method 1 of 2:Using the Constant Yield Method

This logic appeals to accountants but the SLA method is easier to calculate. If deferring current income is your primary consideration, you might choose EIRA for premium bonds and SLA for discount bonds. One way to calculate the amortization over the life of the bond is by using the straight-line method of amortization of bond premium amounts.

### What is the difference between cost and amortized cost?

Amortized cost is that accumulated portion of the recorded cost of a fixed asset that has been charged to expense through either depreciation or amortization. Depreciation is used to ratably reduce the cost of a tangible fixed asset, and amortization is used to ratably reduce the cost of an intangible fixed asset.

The interest income on a debt-investment issued at premium must be similarly lower than interest received. This is because we paid an amount higher than the face value on purchasing the bond but on maturity we will get only the face value. Through the process of amortization, this difference is written off against periodic interest receipts. In this case, you’ll debit the bond premium account $410.After the first interest payment, the bond premium account value should be $3,690 or $4,100 – $410. Remember, you credited the bond premium account $4,100 when you bought the bond.

## Federal and Tri-State Area Income Tax Treatment of Amortizable Bond Premium

For example, if the payment frequency is semi-annual, the system divides the yield by 2. If the frequency is quarterly, the system divides the yield by 4. Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date.

When market interest rates decrease, for any given bond, the fixed coupon rate is higher relative to other bonds in the market. It makes the bond more attractive, and it is why the bond is priced at a premium.

## SLA — Discount Bonds

When market interest rates rise, for any given bond, the fixed coupon rate is lower relative to other bonds in the market. It makes the bond more unattractive, and it is why the bond is priced at a discount. Below is a comparison of the amount of interest expense reported under the effective interest rate method amortizing bond premium 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.

- Therefore, a tax-exempt bond purchased at a premium and held to maturity may result in no capital loss at maturity, because the basis will have been adjusted down to the bond’s face value.
- The accounting treatment for Interest paid and bond premium amortized will remain the same, irrespective of the method used for amortization.
- The bond premium allocable to an accrual period is determined under this paragraph .
- The premium is amortized by crediting the Investment in Bonds account.

Based on the remaining payment schedule of the obligation and C’s basis in the obligation, C’s yield is 5.48 percent, compounded annually. Therefore, the bond premium allocable to the accrual period is $2,420.55 ($9,000−$6,579.45). Based on the remaining payment schedule of the bond and A’s basis in the bond, A’s yield is 8.07 percent, compounded annually. Therefore, the bond premium allocable to the accrual period is $1,118.17 ($10,000−$8,881.83).

## CFR § 1.171-2 – Amortization of bond premium.

At issue, you debit cash for the $1.041 million sale proceeds and credit bonds payable for $1 million face value. You plug the $41,000 difference by crediting the adjunct liability account “premium on bonds payable.” SLA reduces the premium amount equally over the life of the bond. In this example, you semi-annually debit the premium on bonds payable by the original premium amount divided by the number of interest payments, which is $41,000 divided by 10, or $4,100 per period. In the same transaction, you debit interest expense for $40,900 and credit interest payable or cash for $45,000. In the straight-line method of amortization of bond discount or premium, bond discount or premium is charged equally in each period of the bond’s life.

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