Question

Question: What is the required method of amortizing discount and premium on bonds payable? Explain the procedures.

Short answer

Answer

The required method of amortizing discount and premium on bonds payable is effective interest and the straight-line method.

The effective interest method is a method for evaluating the existing rate of interest in a period. The straight-line method is a method of estimating amortization as well as depreciation.

Step-by-step solution

Meaning of Bonds Payable

Bonds payable is defined as an accounting obligation that consists of the value that the issuer has to pay to the bondholders. It is usually reflected within the long-term liabilities portion of the balance sheet, as bonds usually mature after a year.

Effective interest method

The effective interest method is a procedure for estimating the real rate of interest in a period dependent on the value of an accounting instrument’s carrying amount at the initial phase of the financial period. If the carrying amount of an accounting instrument decreases, then the value of the interest associated with it will also decrease. A bond premium takes place when the investors want to pay higher than the book value of the bond, as its coupon interest rate is higher than the existing current interest rate. Whereas a bond discount occurs when investors want to pay lower than the par value of the bond, as its coupon interest rate is less than the existing market rate.

Straight-line method

In a straight-line method, a discount on a bond or premium is charged uniformly in each period of the life of the bond. When the conversion rate on a bond is less than the current interest rate, the bond is issued at a discount to face value. However, if the conversion rate is more than the current interest rate, the bond is issued at a premium to its face value. In the case of a bond issued on discount, the book value is equivalent to par value minus the discount on the bond, whereas, in the case of the issue on premium, the book value is the equivalent face value plus unamortized premium.