5.7 Bond Accounting- Premium vs. Discount Bonds: An Analysis

Discount Bonds

In the case of any discount bond, the coupon rate of interest is less than the yield-to-maturity. From the investor’s perspective, this can be described as “you get less (coupon than market yield), you pay less.” Therefore, the coupon interest paid in dollars is less than the interest expense. The expense is based on the market yield (Y-T-M).

Given that the difference in coupon and interest expense calculations goes to amortization, the issuer is essentially paying added expense – above the coupon payments – over time in the amount of the full bond discount. The issuer is paying both the coupon ($70,000 per year) and the discount ($25,763) spread out over the life of this three-year bond. The entire coupon payment plus the (upward) amortization of the discount are both expensed by the end.

Premium Bonds

The premium bond case is different. We will again use the premium bond from the start of this chapter, with a price of $1,026,710. Here, the coupon exceeds the yield. Some of the coupon payments go towards amortization (downward) of the bond premium. The difference in coupon interest ($70,000 each year) and interest expense ($61,603 in the first year) is amortization ($8,397 in the first year); stated differently, the amortization is a simple return of the bond premium paid back to the investor, i.e., a “return of capital.” This return should not be expensed.