Net Interest Cost NIC: Calculation, Example, Limitations
Our interest rate assumption will be set at a fixed 5%, and we’ll create a circularity switch (and name it “Circ”). We’ll now move to a modeling exercise, which you can access by filling out the form below.
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The straight line bond amortization method is one method of amortizing the premium or discount on bonds payable over the term of the bond, the alternative more acceptable method is the effective interest rate method. The advantage of the straight line method, is that the amortization is simple to calculate and the interest expense and therefore the bond accounting journals, are the same for each period over the lifetime of the bond. Compute the interest expense for bonds issued at a discount to par, meaning the issuing price is less than the par value. This occurs when the prevailing market interest rate is greater than the coupon rate. The straight-line method amortizes this discount equally over the life of the bond.
Straight Line Bond Amortization of a Premium
Net interest cost (NIC) takes into account any premium or discount applicable to the issue (that is, whether the bond is selling above or below face value). It also factors in the dollar amount of coupon interest, which is the periodic rate of interest paid by the issuers to its purchasers over the life of the bond. Forecasting interest using the average debt balance is the more intuitive approach, because a company repays debt over the borrowing term (and reduced principal directly results in less interest). The face value of the bond is the price that the bond issuer will pay at its maturity.
Suppose, for example, a business issued 8% 2-year bonds payable with a par value of 120,000 and semi-annual payments, in return for cash of 122,204 representing a market rate of 7%. The straight line bond amortization method simply involves calculating the total premium or discount on the bonds and then amortizing this to the interest expense account in equal amounts over the lifetime of the bond. The straight line amortization method is one method of calculating how the premium or discount on bonds payable should be amortized to the interest expense account over the lifetime of the bond. If bonds payable are issued by a business at a value other than their par value a premium or discount on bonds payable is created in the accounting records of the business. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation.
Similarly, convertible bonds give investors the chance to convert their bonds to stock in a company, and some bonds give bondholders the right to choose the time at which they wish to do so. With any bond, you can at least get a ballpark range of likely total bond interest expense by looking at worst-case and best-case scenarios. Once calculated, interest expense is usually recorded by the borrower as an accrued liability. The entry is a debit to interest expense (expense account) and a credit to accrued liabilities (liability account). When the lender eventually sends an invoice for the expense, the credit is shifted to the accounts payable account, which is another liability account. When the interest is paid, the accounts payable account is debited to flush out the amount, and the cash account is credited to show that funds were expended.
Calculate Expense for Premium Bonds
When they do, they take on a financial obligation that can last for years or even decades. It’s therefore important to calculate exactly how much in total bond interest expense a company will take on when it offers a bond. With some bonds, it’s simple to figure out total bond interest expense, but with others, it’s impossible to know with certainty. Usually, the bond maturity period refers to the length of time how to find bond interest expense that the bond issuer will pay interest to investors before ceasing and returning the principal to them. The table starts with the book value of the bond which is the par value (120,000) less the discount on bonds payable (2,152), which equals the amount of cash received from the bond issue (117,848).
- The final bond accounting journal would be to repay the par value of the bond with cash.
- Interest expense does not include other fixed payment obligations of a company such as paying dividends on preferred stock.
- When calculating the total bond interest expense, you need to consider the coupon rate and whether the bond was sold at face value (par value), discount or premium.
- Debits increase asset accounts, such as cash, and expense accounts, such as interest expense.
And it may be better to use an interest expense calculator for bonds to determine how much a company will incur over the reporting period, since it has to account for amortization. Bond interest expense refers to the total interest expense that a bond-issuing organization incurs during the reporting period for its bonds payable. And the bonds payable is a record on the balance sheet that shows that a company has issued a bond and borrowed money. Companies that have access to the credit markets routinely issue bonds to raise capital.
The interest expense is a function of the coupon or nominal interest rate, the par value and the issuing price. Record the interest expense when you prepare the financial statements for an accounting period and record the cash interest payment. A simple answer for traditional bonds Most bonds involve companies paying a specified interest rate for the stated length of time between when the company issues the bond and its maturity. To figure out the total interest paid, you take the face value of the bond, multiply it by the coupon interest rate, and then multiply that by the number of years corresponding to the term of the bond. Notice that the effect of this journal is to post the interest of 4,249 to the interest expense account. A tougher answer for other types of bonds Bonds other than traditional bonds involve more uncertainty.
Also not included in interest expense is any payment made toward the principal balance on a debt. For example, if a company pays $1 million to its creditors and $200,000 is applied toward the principal debt, then the interest expense is $800,000. It can have slightly different meanings depending on the context, but in corporate finance, interest expense is generally the primary financing expense on a company’s income statement.