Fixed income instrument

chandniwadhwani92
Finance Junkie
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Fixed income instrument

Postby chandniwadhwani92 » Mon Oct 06, 2014 8:00 am

What is amortization of premium and discount???????

edupristine
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Fixed income instrument

Postby edupristine » Mon Oct 06, 2014 9:21 am

Amortization

A business or government may issue bonds when it needs a long-term source of cash funding. When an company issues bonds, either of the two can occur:
investors are likely to pay less than the face value of the bonds when the stated interest rate on the bonds is less than the prevailing market interest rate.

Or investors are likely to pay more than the face value of the bonds when the stated interest rate on the bonds is greater than/exceeds the prevailing market interest rate.

Let us consider the case of Amortization of premium in order to understand it better.
XYZ issues $10,000,000 of bonds at an interest rate of 8%, which is somewhat higher than the market rate at the time of issuance. Accordingly, investors are willing to pay more than the face value of the bonds, which drives down the effective interest rate that they receive. Thus, XYZ receives not only $10,000,000 for the bonds, but also an additional $100,000, which is a premium over the face value of the bonds.

XYZ must then reduce the $100,000 premium on its bonds payable during each accounting period that the bonds are outstanding, until the balance in the Premium on Bonds Payable account is zero when the company has to pay back the investors. The bonds have a term of five years, so that is the period over which ABC must amortize the premium.

There are two ways for XYZ to amortize the premium. Since the premium is so small, it can amortize the amount on a straight-line basis, and simply credit $20,000 to interest expense in each year.

As the balance in the premium on bonds payable account declines over time, this means that the net amount of the bonds payable account and premium on bonds payable account presented in the balance sheet will gradually decrease, until it is $10,000,000 as of the date when the bonds are to be repaid to investors.

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.

Similar is the concept of amortization of discount.


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