What Is an Amortizable Bond Premium?

The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.

Understanding an Amortizable Bond Premium

A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.

The difference between the bond’s current price (or carrying value) and the bond’s face value is the premium of the bond. For example, a bond that has a face value of $1,000 but is sold for $1,050 has a $50 premium. Over time, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The gradual decrease in the value of the bond is called amortization.

Cost Basis

For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes.

Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.

In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a bond premium every year.

Amortizing Bond Premium With the Constant Yield Method

The constant yield method is used to determine the bond premium amortization for each accrual period. It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form:

• Accrual = Purchase Basis x (YTM /Accrual periods per year) – Coupon Interest

The first step in calculating the premium amortization is to determine the yield to maturity (YTM), which is the discount rate that equates the present value of all remaining payments to be made on the bond to the basis in the bond.

For example, consider an investor that purchased a bond for $10,150. The bond has a five-year maturity date and a par value of $10,000. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period.

The First Period

Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the second period is the next six months, after which the investor receives the second coupon payment, and so on. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2.

Following our example, the yield used to amortize the bond premium is 3.5%/2 = 1.75%, and the coupon payment per period is 5% / 2 x $10,000 = $250. The amortization for period 1 is as follows:

• Accrual_period1 = ($10,150 x 1.75%) – $250
• Accrual_period1 = $177.63 – $250
• Accrual_period1 = -$72.38

The Second Period

The bond’s basis for the second period is the purchase price plus the accrual in the first period—that is, $10,150 – $72.38 = $10,077.62:

• Accrual_period2 = ($10,077.62 x 1.75%) – $250
• Accrual_period2 = $176.36 – $250
• Accrual_period2 = -$73.64

For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.

Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes.

What Is the Amortization of Intangibles?

Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.

Understanding the Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don’t have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it’s one of the ones included in Section 197.

Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.

Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.

Special Considerations

When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary’s net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm’s balance sheet when it is purchased.

IP can also be internally generated by a company’s own research and development (R&D) efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.

In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with GAAP, which requires the matching of revenue with the expense incurred to generate the revenue.

Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset—the value that the asset can be sold for at the end of its useful life. Amortization doesn’t take into account a salvage value.

Types of Amortization

For accounting (financial statement) purposes, a company can choose from six amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum-of-the-years’ digits, and units of production.

For tax purposes, there are two options for amortization of intangibles that the IRS allows. These are straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).

Example of Amortization

Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value—in this case, $4,000—divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 – $4,000) ÷ 8.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm’s accounting department posts a $10,000 amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.

What Is the Additional Child Tax Credit?

The additional child tax credit was the refundable portion of the child tax credit. It could be claimed by families who owed the IRS less than their qualified child tax credit amount. Since the child tax credit was non-refundable, the additional child tax credit refunded the unused portion of the child tax credit to the taxpayer. This provision was eliminated from 2018 to 2025 by the Tax Cuts and Jobs Act (TCJA).

However, under the TCJA, the child tax credit includes some provisions for refundable credits. In addition, on March 11, 2021, President Biden’s American Rescue Plan was voted into law and made child tax credits fully refundable in 2021.

Understanding the Additional Child Tax Credit

A tax credit is a benefit given to eligible taxpayers to help reduce their tax liabilities. If Susan’s tax bill is $5,550 but she qualifies for a $2,500 tax credit, she will only have to pay $3,050. Some tax credits are refundable, meaning that if the tax credit amounts to more than what is owed as tax, the individual will receive a refund. If Susan’s tax credit is actually $6,050 and is refundable, she will be given a check for $6,050 – $5,550 = $500.

Depending on what tax group a taxpayer falls in, they may be eligible to claim a tax credit. For example, taxpayers with children may qualify for the child tax credit which helps to offset the costs of raising kids.

For the 2022 through 2025 tax year, the child tax credit allows eligible tax filers to reduce their tax liability by up to $2,000 per child. To be eligible for the child tax credit, the child or dependent must:

• Be 16 years or younger by the end of the tax year
• Be a U.S. citizen, national, or resident alien
• Have lived with the taxpayer for more than half of the tax year
• Be claimed as a dependent on the federal tax return
• Not have provided more than half of their own financial support
• Have a Social Security number

Child Tax Credit vs. Additional Child Tax Credit

Previously, the child tax credit was non-refundable, which means the credit could reduce a taxpayer’s bill to zero, but any excess from the credit would not be refunded. Families who wanted to keep the unused portion of the child tax credit could go the route of another available tax credit called the additional child tax credit.

This credit was a refundable tax credit that families could qualify for if they already qualified for the non-refundable child tax credit. The additional child tax credit was ideal for families who owed less than the child tax credit and wanted to receive a refund for the surplus credit.

While the additional child tax credit was eliminated in 2018 under the Tax Cuts and Jobs Act (TCJA), up to $1,400 of the $2,000 child tax credit can be refundable for each qualifying child if certain conditions are met. For example, a taxpayer needs to earn more than $2,500 for the tax year to qualify for any refund. To claim a refund, filers must complete Schedule 8812.

The American Rescue Plan created major changes to the child tax credit for 2021. The maximum credit rose to $3,000 (children up to 17) or $3,600 (children younger than six). Qualifying families started receiving monthly checks (half of the full credit) in July 2021. The credit also became fully refundable in 2021, and families may claim the second half of the credit on their 2021 tax return. This child-related tax benefit begins to phase out for individual filers with children who earn more than $75,000 and joint filers earning more than $150,000.

Example of the Additional Child Tax Credit

Before the TCJA, the IRS allowed families with an annual income of more than $3,000 to claim a refund using the additional child tax credit. The tax credit depended on how much the taxpayer earned and was calculated by taking 15% of the taxpayer’s taxable earned income over $3,000 up to the maximum amount of the credit, which was then $1,000 per child. The total amount above $3,000 (subject to annual adjustments for inflation) was refundable.

For example, a taxpayer with two dependents qualifies for the child tax credit. Their earned income is $28,000, which means income over $3,000 is $25,000. Since 15% x $25,000 = $3,750 is greater than the maximum credit of $2,000 for two kids, they would have received the full portion of any unused credit.

So if the taxpayer received an $800 child tax credit, they would be refunded a $1,200 Additional child tax credit. However, if the taxable earned income was $12,000 instead, 15% of this amount over $3,000 is 15% x $9,000 = $1,350. Because the refundable portion of the credit cannot exceed 15% of earned income above $3,000, the taxpayer would receive a maximum refund of $1,350, not $2,000.

Taxpayers who were residents of Puerto Rico with income below $3,000 were eligible if they had at least three qualifying dependents and paid Social Security tax in excess of the amount of their earned-income credit for the year.

What Is Accounting Conservatism?

Accounting conservatism is a set of bookkeeping guidelines that call for a high degree of verification before a company can make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered. In contrast, revenues can only be recorded when they are assured of being received.

How Accounting Conservatism Works

Generally Accepted Accounting Principles (GAAP) insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.

Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.

A cautious approach presents the company in a worst-case scenario. Assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses, on the other hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the company’s way, they are advised to ignore it until it actually occurs.

Recording Revenue

Accounting conservatism is most stringent in relation to revenue reporting. It requires that revenues are reported in the same period as related expenses were incurred. All information in a transaction must be realizable to be recorded. If a transaction does not result in the exchange of cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to be reported.

Advantages of Accounting Conservatism

Understating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.

Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.

Disadvantages of Accounting Conservatism

On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. That means that some companies will always find ways to manipulate them to their advantage.

Another issue with accounting conservatism is the potential for revenue shifting. If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods to be overstated, making it difficult for an organization to track business operations internally. 

Using Accounting Conservatism

Accounting conservatism may be applied to inventory valuation. When determining the reporting value for inventory, conservatism dictates the lower of historical cost or replacement cost is the monetary value.

Estimations such as uncollectable account receivables (AR) and casualty losses also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles.

However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to the financial statements. Contingent liabilities such as royalty payments or unearned revenue are to be disclosed, too.