When bonds are originally sold at a discount using the straight-line amortization method, the interest expense recognized over time will increase. This accounting treatment systematically adjusts the bond's value and its related expense over its life.
Understanding Bond Discounts and Straight-Line Amortization
A bond discount occurs when a bond is sold for less than its face value (also known as par value). This typically happens when the stated interest rate (coupon rate) on the bond is lower than the prevailing market interest rate for similar investments at the time of issuance.
The straight-line amortization method is a way to allocate the bond discount evenly over the bond's useful life. Instead of applying a fluctuating interest rate, this method distributes the total discount amount equally across each interest period.
Impact on Carrying Value and Interest Expense
The straight-line amortization process has a direct impact on the bond's carrying value and the recognized interest expense:
- Discount Distribution: The total bond discount is divided by the number of interest periods over the bond's life. This fixed amount of discount is amortized each period.
- Increasing Carrying Value: Each time the discount is amortized, it is added to the bond's carrying value on the balance sheet. This means the bond's book value steadily increases over time, moving from its initial discounted sale price towards its face value at maturity.
- Rising Interest Expense: As the bond's book value rises due to the consistent amortization of the discount, the interest expense recognized is said to increase over time. This reflects the increasing carrying value of the bond on the company's books. This total interest expense typically combines the cash interest paid (which remains constant) and the amortized portion of the discount.
Illustration of Amortization Principle
To illustrate, consider a bond with a discount. Each accounting period, a portion of this discount is recognized as additional interest expense. This process can be visualized as follows:
- Initial Sale: The company receives less cash than the bond's face value.
- Periodic Amortization:
- The bond issuer pays the stated cash interest to bondholders.
- An equal portion of the original bond discount is recognized as additional interest expense.
- This discount amortization effectively increases the bond's carrying value on the balance sheet.
Financial Statement Effects
- Income Statement: The interest expense reported on the income statement will show an increase over the life of the bond, as the amortized discount contributes to a growing total interest cost.
- Balance Sheet: The bonds payable account will display an increasing carrying value from the original discounted amount, eventually reaching the face value at the bond's maturity.
This methodical approach ensures that by the time the bond matures, its carrying value equals its face value, and the entire discount has been fully recognized as interest expense over the bond's life.
