I'm Larry Walther, this is principlesofaccount.com, Chapter 13.
In this module, we will continue our discussion of accounting for
bonds payable.
Now, however, we are going to shift from the straight line
to the Effective-interest amortization methods.
And so, let's first recall under the Effective-interest amortization method.
Interest expense will be recognized as a constant percentage
of a bond's carrying value, rather than as an equal amount each period,
as was the case under the straight line approach.
Interest expense is calculated as the bond's carrying value,
that is the face amount of the bond, or
par amount, plus any unamortized premium, or minus any unamortized discount.
The net of those amounts, the carrying value times the effective interest rate
that was implicit in the bond at the time it was issued.
And we'll see examples of this in a moment.
The amount of amortization is the difference between the cash paid for
interest during a period, and the amount that's calculated
under the formulation of carrying amount times effective interest rate.
To illustrate, recall from our previous illustrations that we had a bond that
was priced to yield 6%.
And this was an 8% bond, and it was priced at $108,530.
In a previous module as well as the textbook, this calculation is illustrated.
So for now, let's assume it's just a correct number, 108,530.
The effective interest rate for the very first six-month period of holding
that bond will calculate to be $3,255.90.
That's the 108,540 times the 6% effective rate for six months or
times six-twelfths of a year.
So, we take that total $3,255.90 of interest, and
compare that to the 4,000 that is being paid,
that is it's an 8% stated right bond, 8% times the 100,000,
times half of a year, would give us 4,000 as the cash that's paid.
The difference between that 4,000 cash paid on the one hand, and the calculated
amount of interest on the other hand, gives us the premium amortization of $744.
Now, that premium amortization serves to reduce the net book value of the bond.
That is, after recording the amortization, the carrying value will be reduced
to 107,785, the beginning amount minus the premium amortization.
Over time, we started with the $8,530 of premium, it's going to be completely
amortized over the life of the bond through this effective-interest method.
That new balance that's established for the next period, that is the 107,785,
that is the benchmark upon which interest will be calculated during the next period.
And here is an amortization table to illustrate this.
So we start out with $108,530.
We multiply that times the effective interest rate,
and reflect that it's only for six months of the year.
And we calculate interest expense at 3,255, compared to the $4,000 payment,
gives us a different of 744, or the premium amortization.
That reduces the premium and leaves the new carrying value, the bond payable,
plus the unamortized premium at 107,758.90,
that becomes the balance for the next premium calculation.
And we would calculate interest on that, and it would come to $3,233.
This process would continue,
as you can see in the amortization table period after period.
Notice that in the very last period, the bond's carrying value of 100,970
times the 6% for half a year would gives us interest expense of 3,029,
compared to the $4,000 paid would give rise to $970 of premium
amortization enough to exactly reduce the bond to its 100,000 phase amount.
The amount that's been due at the maturity date on December 31, of year five.
So, it's a perfect process if the numbers are carried out exactly correctly.
It's a perfect process, so that over the life of the bond,
the premium will be completely amortized, and each period, the interest
expense is reflected as 6% of the bonds carrying value for that period of time.
Let's look at a journal entry.
The initial journal entry to record the bond issuance,
as well as the subsequent entry that record repayment of the bond at maturity,
would be identical to those illustrated under the straight line method.
We won't repeat those here.
However, we would record a little bit different amount of periodic expense.
So for example,
for our June 30th year three example, we're debiting interest expense, 3,162.
You can find that amount on the amortization table,
which is reproduced on the textbook.
We're debiting premium on bonds payable for the difference between that, and
the credit cash $4,000 payment.
We can repeat this process looking at a discount.
We had another scenario where the bonds were priced to yield 10%,
and that came out at $92,278.
Now, the effective interest rate for
the first six months is 9278 times 10% for half a year, that is $4,613.
Of that amount, $4,000 is paid in cash,
that's still our 8% stated rate calculation.
The difference between the expense and
the cash payment is discount amortization of $613.90.
And the discount amortization increases the net book value of the debt after
the first period to 92,891, that is the beginning balance of $92,278 plus $613.
That new balance, that is the 92,891.90,
would become the balance on which interest expense is calculated for the next period.
Here is an amortization table.
Again, this is reproduced on the book.
We start out with our balance 92,278.
We calculated interest there on it, 4,613, compared to the $4,000 cash payment,
gives us the discount amortization of $613.90, and
that reduces the balance to 92,891.90, which is the amount upon which interest
is calculated for the next period, and the process repeats period after period.
The initial journal entry to record the issuance of the bonds, and
the final journal entry to record repayment at maturity,
would be identical to those that were illustrated when we looked at this problem
under the straight-line method in the previous module.
However, each journal entry would record a little bit
different amount of periodic expense.
Now in this case, in the journal entry for
June 30th of year three, we're debiting interest expense $4,746,
that's the calculated amount for our amortization table.
Bear in mind, only 4,000 of that is paid in cash, the credit to cash.
The difference is our discount amortization, 746.20.
Now we're crediting the discount account as we amortize it.
Remember, it has a debit balance, it's a contra-account to the debt account, so
we're crediting it to reflect the decline in that discount account over time.
And that will take the discount account balance to exactly zero at maturity.