The amortization of a bond and the indirect method of cash flow both involve non-cash interest expense. When solving for cash flow using the indirect method, accountants must adjust any non-cash expenses from net income, an accounting profit containing both cash and non-cash expense elements. Thus with bond amortization, accountants further discount, or adjust, the indirect method of cash flow on related interest expense. Depending on the type of bond amortization, the adjustment to net income can be an addition or a subtraction.
Bond amortization is a process of allocating the amount of bond discount or bond premium to each of a bond's interest-paying periods over the term of the bond. Bonds may issue at a discount or a premium to their face value when the market interest rate is higher or lower than a bond's coupon rate. While coupon interest is the amount of interest payment in cash for each interest-paying period, the amount of bond discount amortization or bond premium amortization in each period adds to or subtracts from the period's coupon payment to arrive at the effective interest expense used in net income calculation.
Indirect Method of Cash Flow
The indirect method computes cash flow from operating activities based on net income. Net income is not cash flow and accountants must adjust this by including any cash inflow and cash outflow that do not count as revenues and expenses, and by excluding any non-cash revenues and non-cash expenses. For example, when an accountant previously uses a non-cash expense to calculate the net income, the accountant adds back the amount of non-cash expense to solve for cash flow. In addition, when an accountant does not consider cash outflow as an expense and does not use it in the net income calculation, the accountant must subtract the amount of non-expense cash outflow from net income to solve for cash flow.
The amortization of a bond discount always results in an actual, or effective, interest expense that is higher than the bond's coupon interest payment for each period. When a bond sells at a discount, the actual, or market, interest rate is higher than the coupon, or nominal, rate. Therefore, accountants add the amount of bond discount amortization for each period to the coupon payment in cash to arrive at the actual interest expense for net income calculation. To solve for cash flow, accountants add the non-cash part of the interest expense in the bond discount amortization back to net income.
The amortization of a bond premium always leads to the bond's actual, or effective, interest expense to be lower than the bond's coupon interest payment for each period. When a bond sells at a premium, the actual, or market, interest rate is lower than the coupon, or nominal, rate. Therefore, accountants subtract the amount of bond premium amortization for each period from the coupon payment in cash to arrive at the actual interest expense for net income calculation. To solve for cash flow, accountants subtract from net income as cash outflow the part of the coupon payment in cash not counted as interest expense in the bond premium amortization.