Definition: Straight-line amortization is a method of allocating interest to a bond equally throughout its life. In other words, this is the process of recording the interest expense associated with a bond equally each accounting period until its maturity date.
What Does Straight Line Amortization Mean?
The straight-line amortization method is the simplest way to amortize a bond or loan because it allocates an equal amount of interest over each accounting period in the debt’s life. The straight line amortization formula is computed by dividing the total interest amount by the number of periods in the debt’s life. This amount will be recorded as an expense each year on the income statement.
Most bank loan and mortgage amortization schedules are pretty self explanatory with the straight-line method. Bonds, on the other hand, can be issued at a discount, premium, or market rate resulting in a slightly more complex amortization schedule. Let’s take a look at a bond example.
Tiger’s Golf Cart Company has been selling carts and golf equipment for years and is now looking to expand its operations over seas. Instead of trying to attract new investors, Tiger has decided to issue bonds to pay for the expansion. Tiger issues a $100,000 10 percent bond five-year semi-annual bond, but because of the current market conditions, he had to issue it at a discount of 2 percent. Instead of receiving a full $100,000 from creditors, Tiger will only receive $92,277. Tiger will however have to pay its creditors back a total of $140,000 ( $100,000 principle and $40,000 interest ).
To calculate the straight-line method, we must take the total interest payments and divide them by the bond life. This is where it gets tricky. Tiger is paying $40,000 of interest explicitly, but he is also paying $7,723 of interest implicitly because of the discount. So we would divide $47,723 by five years to find the amount of interest recorded each period.
At the end of the each accounting period, Tiger would record a journal entry by debiting interest expense for $4,772 and crediting discount on bonds payable for $772 and cash for $4,000.