I’ve been scratching my head the past couple of days over the subject of Bond Amortization… I wonder if anyone could enlighten me please…
I don’t really understand the whole concept of why we amortize bonds in the first place?
What is the benefit to the bond issuer?
In the perspective of the investor, can they also amortize bonds? If so, why would they want to do this?
If the coupon paid out to bondholders is the coupon rate x par value, why do the accountancy standards let us recognise an interest expense equal to the beginning book value x market discount rate? This is totally different to what we just paid out isn’t it?
We amortize bond premia and discounts primarily because it’s fun to do so.
Secondarily, we do it so that the gain or loss is recognized over the life of the bond, rather than recognizing it in a lump sum at the bond’s maturity. It’s a matching principle thing.
Issuers do it, investors to it, everybody does it. It’s the thing to do. Like buying hula hoops.
In the first year, why do we recognise interest expense of $10,731 (11% of $97.56) when the coupon actually paid to the bondholder is $10 (0.10 x par value)?
Think of it this way: if we weren’t such cheapskates, we’d have paid the market the 11% coupon that it wanted. But NO! We wanted to pay only 10%. Because of that , we have a built-in loss on the bond of $2.44 (= $100 – $97.56). We spread that loss out over three years: roughly 81¢ (= $2.44 ÷ 3) per year. Using the effective rate method, we’ll show somewhat less than 81¢ the first year (73¢ by your calculation), about 81¢ the second year, and somewhat more than 81¢ the third year (about 90¢). Under US GAAP, we could have amortized the discount straight-line and shown roughly 81¢ every year.
As to why we call it interest expense: well, we could report it separately as the amortization of the discount, but, as I said above, if we weren’t cheapskates we’d have been paying 11% on $100: $11 per year in interest. So including the amortization in the interest expense makes it more akin to what we should have done in the first place.