Bond accounting, particularly the amortization of premiums and discounts, is one of the most reliable topics on the FAR section of the CPA Exam. You can almost guarantee you will see multiple questions involving bonds, and the questions tend to follow predictable patterns. If you learn the effective interest method and can build an amortization table, you will be well positioned to pick up easy points on exam day.
This guide takes you through bond amortization step by step, from the initial issuance to ongoing amortization to early retirement. We will focus on the effective interest method since that is what GAAP requires and the exam emphasizes, but we will also touch on the straight-line method since the exam occasionally tests it.
Why Bonds Are Issued at a Premium or Discount
Understanding why premiums and discounts exist is essential to understanding amortization. A bond has a stated rate (also called the coupon rate or nominal rate) and the market has a market rate (also called the effective rate or yield rate). These two rates are rarely identical.
- If the stated rate equals the market rate: The bond sells at par (face value). No premium or discount.
- If the stated rate exceeds the market rate: The bond is more attractive than the market, so investors are willing to pay more. The bond sells at a premium (above face value).
- If the stated rate is less than the market rate: The bond is less attractive than the market, so investors demand a discount. The bond sells at a discount (below face value).
The premium or discount represents the present value adjustment needed to bring the stated interest rate in line with the market rate. Over the life of the bond, the premium or discount is amortized so that by maturity, the carrying amount equals the face value.
Initial Issuance Journal Entries
When a bond is issued at a premium:
Debit: Cash (face value + premium)
Credit: Bonds Payable (face value)
Credit: Premium on Bonds Payable (premium amount)
When a bond is issued at a discount:
Debit: Cash (face value - discount)
Debit: Discount on Bonds Payable (discount amount)
Credit: Bonds Payable (face value)
The carrying amount of the bond is always the face value plus any unamortized premium or minus any unamortized discount.
The Effective Interest Method
The effective interest method is the preferred method under GAAP and the one the CPA Exam tests most heavily. The core concept is straightforward:
- Calculate interest expense = Carrying amount at the beginning of the period multiplied by the market (effective) rate.
- Calculate cash interest payment = Face value multiplied by the stated rate.
- Calculate amortization = The difference between interest expense and the cash interest payment.
For a discount bond:
- Interest expense is greater than the cash payment.
- The difference is the discount amortization, which increases the carrying amount.
- Each period, the carrying amount gets closer to face value.
For a premium bond:
- The cash payment is greater than interest expense.
- The difference is the premium amortization, which decreases the carrying amount.
- Each period, the carrying amount gets closer to face value.
Building an Amortization Table
The amortization table is your single most powerful tool for bond questions on the CPA Exam. Here is how to set one up:
Column headers:
- Period
- Cash Interest (face value times stated rate)
- Interest Expense (beginning carrying amount times market rate)
- Amortization (difference between columns 2 and 3)
- Carrying Amount (previous carrying amount plus or minus amortization)
Start with the issuance price as the initial carrying amount, then fill in each period. For a discount bond, the carrying amount increases each period. For a premium bond, it decreases. The last period should bring the carrying amount back to exactly the face value.
Exam tip: The exam often asks for the interest expense or carrying amount at a specific period. If you build the table quickly and accurately, you can answer these questions with complete confidence. Practice building tables until you can do it in under two minutes.
Journal Entries for Amortization
For a discount bond:
Debit: Interest Expense
Credit: Discount on Bonds Payable (amortization amount)
Credit: Cash (stated interest payment)
For a premium bond:
Debit: Interest Expense
Debit: Premium on Bonds Payable (amortization amount)
Credit: Cash (stated interest payment)
Notice the pattern: interest expense is always the balancing amount, and it is always equal to the carrying amount times the market rate. The cash payment is always the face value times the stated rate. The amortization is always the difference.
The Straight-Line Method
The straight-line method divides the total premium or discount equally across all interest periods. While it is simpler than the effective interest method, it is only acceptable under GAAP when the results are not materially different from the effective interest method.
Under straight-line, amortization per period is simply the total premium or discount divided by the number of interest periods. Interest expense equals the cash payment adjusted for the per-period amortization.
The exam may test straight-line in situations where it tells you to use that method, but default to the effective interest method unless told otherwise.
Bond Issuance Costs
Under current GAAP (ASU 2015-03), bond issuance costs are presented as a reduction of the carrying amount of the bond rather than as a separate deferred charge. This treatment is similar to a discount. The issuance costs are amortized over the life of the bond using the effective interest method.
On the exam, watch for how issuance costs affect the initial carrying amount and subsequent interest expense calculations.
Early Retirement of Bonds
When a company retires bonds before maturity, it must recognize a gain or loss on the retirement. The calculation is:
Gain or Loss = Carrying Amount at Retirement - Reacquisition Price
If the carrying amount exceeds the reacquisition price, the company records a gain. If the reacquisition price exceeds the carrying amount, the company records a loss. This gain or loss is reported in income from continuing operations.
The exam frequently tests this by giving you a bond that has been outstanding for several years and asking you to calculate the gain or loss on early retirement. You will need to determine the carrying amount at the retirement date by amortizing the premium or discount through that date.
The journal entry for early retirement at a loss:
Debit: Bonds Payable (face value)
Debit: Loss on Early Retirement
Credit: Discount on Bonds Payable (unamortized balance)
Credit: Cash (reacquisition price)
Bonds Issued Between Interest Dates
When bonds are issued between interest payment dates, the buyer pays the issuer accrued interest from the last interest date to the issuance date. The issuer then pays a full period of interest on the next interest date. The net effect is that each party receives the correct amount of interest for the period they actually held the bonds.
The exam tests this by asking for the total cash received at issuance (which includes both the issuance price and accrued interest) or by asking for the interest expense in the first partial period.
Exam Strategy for Bond Questions
- Identify the rates immediately. The stated rate gives you cash payments. The market rate gives you interest expense. Never mix them up.
- Build the amortization table. Even if the question only asks about one period, set up the table. It takes 60 seconds and prevents errors.
- Check your direction. Discounts increase the carrying amount. Premiums decrease it. If your carrying amount is moving the wrong way, you have an error.
- Watch for semiannual interest. Many bond problems use semiannual payments. Remember to halve the stated rate, halve the market rate, and double the number of periods.
- Keep early retirement straightforward. Carrying amount minus reacquisition price. Positive is a gain, negative is a loss.
Wrapping Up
Bond amortization is one of the most predictable and scoreable topics on the FAR exam. The questions follow a limited number of patterns, and if you can build an amortization table and understand the effective interest method, you are well on your way to getting every bond question correct.
Think CPA offers targeted bond amortization practice with step-by-step solution explanations that walk you through table construction, journal entries, and early retirement calculations. Our adaptive platform ensures you see the right level of difficulty for where you are in your preparation, building your confidence and speed for exam day.
Start with the fundamentals, practice building amortization tables, and work through early retirement scenarios. Bond amortization is a topic where practice directly translates to exam points.