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."
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 600 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 600 days divided by 1170 days, or $641.03. 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.
