An alternate method of accreting
bond discounts is allowed for TAXABLE
bonds (but not for TAX-EXEMPT bonds)
under the Internal Revenue Code in
place of the "Yield to Maturity" method.
It is called the "Ratable Accrual
Method."
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This method is a lot easier than the "yield to maturity" method because it
is simply a proration of the discount based on the number of days a bond
was owned divided by the number of days from date of purchase to maturity.
Assume the following:
You bought a $25,000 General Electric Co. Note 4% due 9/30/2010.
Purchase date 6/30/2007.
Non-callable.
Price $95.00 per $100 of par value.
Total price paid for bond $23,750
Interest coupon pays semi-annually on March 31 and Sept 30.
Accrued interest at date of purchase $250.
Yield to maturity 5.70%
You subsequently sold the note on 4/30/2009 at a price of $98.00 per $100 of
par value for sales proceeds of $24,500 and also received accrued interest of
$83.33 for one month's interest since the last coupon payment on 3/31/2009.
The length of time between the date of purchase and the date of maturity
was three years and 3 months, or 1170 days (using 30 days per month.) The length
of time between the date of purchase and the date of sale was one year and ten
months or 660 days (using 30 days per month.)
The total amount of discount at the date of purchase was $1,250.00, and the amount
to be accreted at the date of sale is $1,250.00 times 660 days divided by 1170 days,
or $705.13. This amount should be reported as additional taxable interest income
in the year of sale and added to the cost basis of the bond.
Alternatively, if a valid election is made in the year of purchase, the bond discount
can be accreted year by year using the ratable accrual method, rather than
recording all the bond discount accretion income in the year of sale.
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