If the interest paid on the bond is taxable, the premium paid on the bond can be amortized, or in other words, a part of the premium can be utilized towards reducing the amount of taxable income. Also, it leads to the reduction of the cost basis of the taxable bond for premium amortized in each period. However, in the case of tax-exempt bonds, the amortized premium is not deductible while determining the taxable income Determining The Taxable Income The taxable income formula calculates the total income taxable under the income tax.
It differs based on whether you are calculating the taxable income for an individual or a business corporation. But the bond premium has to be amortized for each period, a reduction of cost basis in the bond is necessary each year.
For a Bond investor, the premium paid for a bond represents part of the cost basis of the bond, for tax purposes. Calculation of Bond Premium amortized can be done by any of the two methods mentioned above, depending on the type of bonds.
Both bond amortization methods give the same final results. However, the difference arises in the pace of interest expenses. Straight Line method of amortization Straight Line Method Of Amortization Straight-line amortization amortizes the cost of intangible assets or allocates the interest expenses associated with the bond's issue in each accounting period until the end of the intangible asset or maturity of bond respectively in the income statement.
An effective Interest rate method of amortization, on the other hand, gives decreasing interest expenses over time for premium bonds Premium Bonds Premium bonds are those long-term financial instruments which trade at a price exceeding their face value.
The coupon rate of these bonds is higher because they tend to provide more interest than the standard rate of interest prevailing in the market. In simple words, expenses decrease with a decrease in book value under the Effective Interest rate method. This logic seems very practical, but the straight-line method is easier to calculate.
If the primary consideration is to defer current income, Effective Interest rate method should be chosen for the amortization of premium on bonds.
The Straight Method is preferable when the amount of premium is very less or insignificant. This article has been a guide to what is Premium Bond Amortization and its definition. Here we discuss the top 2 methods to calculate amortization of bond premium along with practical examples, advantages, and limitations. You may learn more about accounting from the following articles —. When a bond is sold at a discount, the total effective interest expense on the bond for the issuer consists of the nominal interest expense that a bond issuer pays in coupon payments over time, and the total amount of bond discount.
Bond discount amortization helps to determine the real periodic interest expense. The effective interest expense on the bond for each payment period is then the sum of the periodic coupon payment and the allocated bond discount amortization.
The amount of periodic bond discount amortization is dependent on the amortization method used. Bond discount amortization also helps adjust the discounted bond carrying value over time.
Because bonds sold at a discount will be repaid at their full face value, total bond discount is added back to arrive at the bond face value. The adjustment is done periodically by adding the allocated amount of bond discount amortization to the corresponding bond carrying value at the beginning of each interest-payment period.
Bond discount amortization has effects on both total interest expense and outstanding bond carrying value. Bond discount amortization over time increases bond carrying value, which in turn increases the total interest expense. An investment and research professional, Jay Way started writing financial articles for Web content providers in This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well.
The cost basis of the taxable bond is reduced by the amount of premium amortized each year. In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year.
The IRS requires that the constant yield method be used to amortize a bond premium every year. The constant yield method is used to determine the bond premium amortization for each accrual period. It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form:. The first step in calculating the premium amortization is to determine the yield to maturity YTM , which is the discount rate that equates the present value of all remaining payments to be made on the bond to the basis in the bond.
Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the second period is the next six months, after which the investor receives the second coupon payment, and so on.
Following our example, the yield used to amortize the bond premium is 3. The amortization for period 1 is as follows:. For the remaining eight periods there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years , use the same structure presented above to calculate the amortizable bond premium. Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes. Internal Revenue Service. Fixed Income Essentials.
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