i understand the idea of amortization.
can someone explain it with bonds… why do we amortize bond discount or premium for calculating interest expense…
Example: You walk into a bank looking for a new mortgage and they offer you two loans, one with points and one without points (note: a point is the equivalent of a bond discount). When you go home you want to compare the two loans to determine which loan has the lower APR. This is why you amortize the bond discount, to figure out what the effective interest rate of the bond is.
We amortize the discount or premium to interpret the REAL cost of debt. This cost may vary significantly from the coupon rate. As you may know, as the market yields rise, the price of the bond decreases. Why? Because no one will buy a bond with a lower coupon than the market. And since the coupon cannot be changed, the price of the bond is decreased by the difference in yields. Now that we sold the bond at a discount, we will still have to return the face value. So, we will still pay the coupon AND have to pay the difference between the face value and the price (after deducting the discount). Since the discount represents the cost of debt just like the coupon, it too is paid in the form of a coupon. But, we have to pay this additional coupon at maturity. In order to avoid a scenario where our debt SUDDENLY increases, we amortize it over the life of the bond considering it a part of the coupon. The same analogy can be applied to premiums.
Or you can view it like this. 4 year Bond issued for $96 when par equals $100 ($4 discount). Company received $4 less than par today so amortizing the discount is a way to recognize this additional expense on top of coupon payments over the bond’s term.