When bonds are issued at premium or discount prices,
the premium or discount balance must be amortized
over the life of the bond.
This means that the balance in those types of accounts
must be written off to interest expense
over the life of the bond.
There are two methods of amortizing premium
and discounts, the effective interest rate
method and the straight method, which
is not GAAP approved unless the results are
similar to the effective interest rate method.
The funny thing is because interest rates in the US
have been so low for over 30 years,
many companies do use the straight line method.
The low end and minimal fluctuation in interest rates
have caused the results of the two methods
to be similar enough that many companies are choosing
the straight line method.
Recall how to calculate interest.
It is principal times rate times time.
However, bond interest is more complicated
because we have two rates, and most bonds
pay interest semiannually, so does that impact time?
Well, let's find out.
The stated rate is the interest rate
we use to calculate the amount of interest
paid to the bondholders.
That is the interest rate stated on the face of the bond,
and really, it's its only purpose.
Since most bonds pay interest semiannually,
time is six months.
When companies issue bonds at premiums or discounts,
the amount of interest expense, and the amount
of interest payable or cash are going to be different.
This is due to the premium or discount
amortization that occurs each time an interest payment is
made.
The straight line method advertises
premiums and discounts evenly over the life of the bond.
Whereas the effective interest rate method
matches interest expense more closely to the bond carrying
value.
This is why it is the method approved by GAAP by the way.
This video will focus on recording interest
using the straight line method.
The formula to amortize a premium or discount
is the balance divided by the number of interest payment
periods.
Now make sure you don't confuse that with years.
If it's a five year bond, but it pays interest semiannually,
than the number of interest payment periods is 10, not 5.
So let's look at the typical example,
and pull out the key information needed
to record interest expense.
Yazzo issues $100,000, 5%, 3 year bonds payable at 98.
The bonds pay interest semiannually.
So the issue price is 98,000, meaning
the discount balance is $2,000.
The interest payment, using the formula principal
times rate times time, is $2,500 every six months.
The amount of discount amortization
will be $333 every time we make an interest payment.
The journal entry is as follows.
We debit interest expense for $2,833,
but this number is a plug number.
So just enter the account name initially,
and then we'll move on to the credits.
The discount on bonds payable has a normal debit balance.
So we need to credit the amount for the amount of amortization,
which is $333.
The cash is then credited for the amount of interest payment
to the bondholders, which is $2,500.
Since the total credit is equal $2,833,
this is the amount that we would debit interest expense.
Since this is the straight line method,
this exact journal entry would be made every six months
over the next three years.
Even though the journal entry repeats with the straight line
method, some companies still prepare an amortization
schedule.
Here you can see the amounts of interest payment, interest
expense, discount amortization, the discount balance,
and the bond carrying amount.
Using the table makes recording the journal entries really
easy, and it's also helpful to verify the account balances are
correct, like we could do here after interest payment
number three.
And here is the balance sheet presentation of this example.
OK.
So let's quickly look at our premium example.
Yazoo issues 100,000, 5 percent, three year bonds
payable at 103.
The bonds pay interest semiannually.
So the issue price is 103, meaning
that premium balance is $3,000.
The interest payment we'll use in the formula
is principle times rate times time,
and that's $2,500 every six months.
The amount of premium amortization
will be $500 each time we make an interest payment.
The journal entry then is followed.
Interest expense is debited for $2,000.
Again, this number is just plugged,
so you may want to just put the account name there and then
move on to the credits initially.
The premium on the bonds payable has a normal credit balance,
so we need to debit the amount for the amount of amortization,
which is $500.
Then cash is credited for the amount of interest payment
to the bondholders, which is $2,500.
In order to make this journal entry balance,
we would debit interest expense for $2,000.
Here is the amortization table.
Again, we would use this to get data for the journal entry
and to verify the balance sheet reporting, which
you can see here.