An amortized bond is a financial certificate that has been reduced in value for recording on financial statements. An amortized bond is one where the discount amount being amortized becomes part of its interest expense over the life of the bond. If a bond is issued at a discount—that is, offered for sale below its par or face value—the discount must be treated either as an expense, or it can be amortized as an asset.
An amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company's interest expense on its income statement. The interest expense, a nonoperating cost, reduces a company's earnings before tax (EBT) and, therefore, the amount of its tax burden.
Specifically, amortization is an accounting method that gradually and systematically reduces the cost value of a limited life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing a bond allows bond issuers to treat the bond discount as an asset over the life of the bond until the bond's maturity date.
The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.
For example, a company may want to raise debt financing and issue a corporate bond with a face value of $100,000, a maturity of five years and an annual coupon payment of 10%. However, interest rates increase, and the company is only able to issue the bond at a discount, selling the bond for $80,000. The $20,000 difference between the face value of $100,000 and the carrying value of $80,000 is the amount that is amortized over the five-year life of the bond.
Each year the company has to pay an amortized amount of $4,000, derived as: ($20,000/5). Additionally, the company has to pay an annual interest charge of $10,000, derived as: ($100,000 x 0.10). Therefore, the company's total annual interest expense is $14,000, which is the addition of the annual amortized amount of $4,000 and the annual interest rate charge of $10,000.
Companies also use the effective interest rate method to amortize bonds. Under this method of accounting, the bond discount amortized each year is equal to the difference between the bond's interest expense and its interest payable. However, this method requires a financial calculator or spreadsheet software to derive.
North Valley Regional High School, in response to much-needed improvements, issued a 15-year amortized bond to help fund operating costs and capital improvements. The bond is projected to cost $323,000 and should reduce the taxpayers burden of the general fund being used to make these needed improvements to the school.