Definition of Amortize Premium, Discount, and Issue Costs
With regards to bonds payable, the term amortize means to systematically allocate the discount on bonds payable, the premium on bonds payable, and bond issue costs to Interest Expense over the remaining life of the bonds. (Bonds are likely to mature 10 years or more after they are issued.)
The most precise way to amortize these amounts is to use the effective interest rate method. However, the straight-line method of amortization, which is less precise and simpler is also acceptable.
Examples of Amortizing Discount on Bonds and Bond Issue Costs
Assume that on January 1, a corporation issues $2,000,000 of 6% Bonds Payable which mature at the end of 10 years. Because the market interest rate for similar bonds was higher than 6%, the corporation received only $1,940,000 from investors. The resulting difference of $60,000 must be recorded in the contra-liability account Discount on Bonds Payable. The corporation must also record the bond issue costs (legal, auditing and filing fees) of $24,000 in the contra-liability account Bond Issue Costs.
On each June 30 and December 31, the corporation must pay interest of $60,000 ($2,000,000 X 6% X 1/2 year). The corporation must also amortize the bond discount and the bond issue costs. The following are pertinent journal entries for each June 30 and December 31 (assuming only calendar year financial statements are issued and the straight-line method of amortization is used):
- Credit Cash for six months of interest $60,000
- Debit Interest Expense for the amount paid $60,000
- Credit Discount on Bonds Payable for $3,000 ($60,000/20 six-month periods)
- Debit Interest Expense for $3,000
- Credit Bond Issue Costs for $1,200 ($24,000/20 six-month periods)
- Debit Interest Expense for $1,200