Ch 13 Multiple Choice Principles of Accounting, Volume 1: Financial Accounting
Since the market rate and the stated rate are the same in this example, we do not have to worry about any differences between the amount of interest expense and the cash paid to bondholders. This journal entry will be made every year for the 5-year life of the bond. The amount of the premium amortization is simply the difference between the interest expense and the cash payment. Another way to think about amortization is to understand that, with each cash payment, we need to reduce the amount carried on the books in the Bond Premium account.
- Under the effective-interest method, the interest expense is calculated by taking the Carrying (or Book) Value ($104,460) multiplied by the market interest rate (4%).
- The amount of premium amortized for the last payment is equal to the balance in the premium on bonds payable account.
- But as time passes, the Premium account is amortized until it is zero.
- Before the bonds can be issued, the underwriters perform many time-consuming tasks, including setting the bond interest rate.
The difference in the amount received and the amount owed is called the discount. Since they promised to pay 5% while similar bonds earn 7%, the company, accepted less cash up front. They did this because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value but paying 7% interest. Because of the time lag caused by underwriting, it is not unusual for the market rate of the bond to be different from the stated interest rate. The difference in the stated rate and the market rate determine the accounting treatment of the transactions involving bonds. When the bond is issued at par, the accounting treatment is simplest.
The interest rate is set by the issuing company and is usually fixed for the life of the bond. The length of time until maturity will affect how much interest you will receive. In other words, the current yield is the coupon rate times the current price of the bond. The current yield of a bond is the rate of return the bond generates.
Investors should know par value and yield to maturity to make sure bonds make sense for them.
Note that under either method, the interest expense and the carrying value of the bonds stays the same. The first difference pertains to the method of interest amortization. Beyond FASB’s preferred method of interest amortization discussed here, there is another method, the straight-line method. This method is permitted under US GAAP if the results produced by its use would not be materially different than if the effective-interest method were used. IFRS does not permit straight-line amortization and only allows the effective-interest method. Recall from the discussion in Explain the Pricing of Long-Term Liabilities that one way businesses can generate long-term financing is by borrowing from lenders.
- The negative is that it makes debt such as mortgages, credit cards, and loans more expensive.
- Interest payments on bonds are made semi-annually, which means that you will receive a payment every six months.
- At some point, a company will need to record bond retirement, when the company pays the obligation.
- As the premium is amortized, the balance in the premium account and the carrying value of the bond decreases.
The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate (5%). Again, we need to account for the difference between the amount of interest expense and the cash paid to bondholders by crediting the Bond Discount account. The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%). Since the market rate and the stated rate are different, we again need to account for the difference between the amount of interest expense and the cash paid to bondholders. To see YTM in action, let’s imagine you pay $950 for a bond with a $1,000 par value that offers a 5% coupon rate and matures in 10 years. Over those 10 years, you’ll receive $500 in coupon payments ($50 annually) and an extra $50 because you only paid $950 for the bond.
What is the stated interest rate of a bond payable?
Since we originally credited Bond Premium when the bonds were issued, we need to debit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received more for the bonds than face value, but it is only paying interest on $100,000. As the discount is amortized, the discount on bonds payable account’s balance decreases and the carrying value of the bond increases. The amount of discount amortized for the last payment is equal to the balance in the discount on bonds payable account. As with the straight‐line method of amortization, at the maturity of the bonds, the discount account’s balance will be zero and the bond’s carrying value will be the same as its principal amount.
It is contra because it increases the amount of the Bonds Payable liability account. The Premium will disappear over time as it is amortized, but it will decrease the interest expense, which we will see in subsequent journal entries. A final point to consider relates to accounting for the interest costs on the bond. Recall that the bond indenture specifies how much interest the borrower will pay with each periodic payment based on the stated rate of interest. The periodic interest payments to the buyer (investor) will be the same over the course of the bond.
Accounting Principles II
If your income fluctuates, you may find it difficult to budget for your payments. This can cause financial strain and may even lead to missed or late payments. LO
13.2When a bond sells at a discount, the carrying value ________ after each amortization entry.
13.3Gingko Inc. issued bonds with a face value of $100,000, a rate of 7%, and a 10-yearterm for $103,000. From this information, we know that the market rate of interest was ________. LO
13.3O’Shea Inc. issued bonds at a face value of $100,000, a rate of 6%, and a 5-year term for $98,000.
It becomes more complicated when the stated rate and the market rate differ. This is the method typically used for bonds sold at a discount or premium. And, as noted earlier, it is often auditors’ preferred how to price business services method to amortize the discount on bonds payable. This method determines the different amortization amounts that need to be applied to each interest expenditure within each calculation period.
Issuance of Bonds
More broadly, with inflation-adjusted yields at their recent highs, there are new opportunities for investors. Since the book value is equal to the amount that will be owed in the future, no other account is included in the journal entry. It should also be noted that, depending on the issuer, amortized bonds can be tax-exempt or taxable. There are strategies that can be leveraged to optimize the tax efficiency of an investor’s bond portfolios, such as investing in tax-exempt bonds. Amortization schedules, bonds payable, bond calculation methods, and more. LO
13.2The cash interest payment a corporation makes to its bondholders is based on ________.
The bondholders have bonds that say the issuer will pay them $100,000, so that is all that is owed at maturity. The premium will disappear over time and will reduce the amount of interest incurred. First, we will explore the case when the stated interest rate is equal to the market interest rate when the bonds are issued.
These lenders, also known as investors, may sell their bonds to another investor prior to their maturity. At some point, a company will need to record bond retirement, when the company pays the obligation. For example, earlier we demonstrated the issuance of a five-year bond, along with its first two interest payments. If we had carried out recording all five interest payments, the next step would have been the maturity and retirement of the bond.