Auditing debt issued at a premium or discount
When a note or bond is issued at a price different from its face amount, the difference is amortized to interest expense over the term so that the rate stays constant on the carrying amount. The auditor recomputes interest expense, tests that the carrying amount rolls forward correctly, and checks classification between current and long-term. A breach of a covenant at the balance sheet date can change classification; see ASC 470 debt classification.
Formulas
- Period count n = years × payments per year. Coupon C = face × stated rate ÷ payments per year. Period yield i = effective annual rate ÷ payments per year.
- Issue price = C × [1 − (1 + i)−n] ÷ i + face × (1 + i)−n. At i = 0 the price is C × n + face.
- Interest expense = beginning carrying amount × i. Amortization = interest expense − C. Ending carrying amount = beginning + amortization.
Worked check, labelled illustrative: face $100,000, 8% coupon paid semiannually, five years, market yield 10%. C = $4,000, i = 5%, n = 10. The annuity factor is 7.721735, so the coupons are worth $30,886.94, and the face amount is worth 0.613913 × $100,000 = $61,391.33. The price is $92,278.27, a discount of $7,721.73.
Standard
ASC 835-30-35 calls for the interest method: a constant rate applied to the amount outstanding at the start of each period. Premiums and discounts are presented as a direct addition to or deduction from the face amount of the debt (ASC 835-30-45-1), and third-party debt issuance costs are deferred, amortized as interest expense like a discount, and presented the same way (ASC 835-30-45-1A).
When to use it, and limits
- It assumes issue on an interest date, whole periods to maturity and a fixed coupon. Floating rates, call or put features, step-up coupons and issuance between interest dates need a different build.
- It amortizes to maturity. Early extinguishment, modifications and convertible features follow other guidance and are not modelled.
- The straight-line column is for comparison. Use it as the reported amount only if you have shown the difference is not material.
- For a level-payment loan with a stated rate, use the loan amortization schedule.
Illustrative figures only. Check the result against your firm's methodology before relying on it.
Common questions
How do you amortize a bond discount with the effective interest method?
Each period, interest expense is the carrying amount at the start of the period times the effective rate per period. The cash coupon is the face amount times the coupon rate per period. The difference is the amortization, which is added to the carrying amount for a discount and subtracted for a premium. On a $100,000 bond with an 8% semiannual coupon sold to yield 10% for five years, the issue price is $92,278.27, period 1 interest expense is $4,613.91 and the discount amortized is $613.91.
What is the effective interest method?
It applies a constant rate to the carrying amount of the debt at the start of each period, so interest expense changes as the carrying amount moves toward face. ASC 835-30-35 calls for it for amortizing discounts and premiums. Other methods, including straight-line, are acceptable only where the result is not materially different from the interest method.
How are debt issuance costs treated?
Third-party costs are deferred and amortized as interest expense over the term of the debt, in the same way as a discount. They are presented on the balance sheet as a direct deduction from the face amount of the debt rather than as an asset. The tool nets them against the issue price, finds the effective rate on the net proceeds, and amortizes the total.
Does the investor use the same schedule?
A holder that keeps the bond to maturity and carries it at amortized cost uses the same effective-rate arithmetic, with interest income in place of interest expense and the carrying amount of the asset moving toward face. Classification and impairment follow the investor's own guidance, which is outside this tool.
Why does the last row end exactly at face?
Cent rounding across many periods can leave a small residual. The final period absorbs it, so the carrying amount ends at the face amount. The schedule totals tie: total interest expense equals the cash coupons plus the discount, or less the premium.
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