Amortization of Premiums: Straight-Line Method Effective-Interest Method

1. Chapter 10 Illustrated Solution: Problem 10-35 Amortization of Premiums: Straight-Line Method Effective-Interest Method

2. General Concerns with Bonds • A bond is like a fixed-payment contract with the interest rates and payment dates already set. • Bonds are often sold when the market rate of interest is different from the stated interest rate on the bonds. • Premium on Bonds • Discount on Bonds.

3. Problem Background • Locust Company sells $20,000 of their bonds to Allen Company for $20,850. • Bonds pay interest of 7% (on face value), or $700 every 6 months. • Assumptions: • Market interest rate at the time bonds are sold is approximately 6%. • The $850 difference between the face value of the bonds and the purchase (sales) price of the bonds will adjust the effective interest rate back to the market rate (approximately 6%).

4. Premium on Bonds—The Concept • Every 6 months Allen Company will receive a payment from Locust Company of $700. • However, Allen Company’s interest revenue will be less than this $700 payment they receive because they paid $20,850 to acquire the bonds and they will only receive a payment of $20,000 when the bonds mature in 5 years. • Locust Company’s true interest expense is less than the $700 payment they make because they received $20,850 when they sold the bonds and they will only have to pay back $20,000 when the bonds mature in 5 years. • Question: How to account for this $850 premium?

5. Straight-Line Method Under the straight-line method, the total premium is amortized evenly over the life of the bonds: In this case: Total Premium $850 Number of Payments 10 = $85 per payment

6. Straight-Line Method Under the straight-line method, the total premium is amortized evenly over the life of the bonds: In this case: Total Premium $850 Number of Payments 10 = $85 per payment In other words, every time Allen Company receives a $700 payment, they will only show $615 as revenue. Similarly, every time Locust Company makes a $700 payment, they will only show $615 as interest expense. The $85 difference will go to amortize the premium.

7. Straight-Line Entries Allen Company Books Bond investment—Locust Sales Company ……… 20,850 Cash …………………………………………….. 20,850 Cash …………………………………………………. 700 Bond Investment—Locust Sales Company … 85 Interest Revenue ………………………………. 615

8. Straight-Line Entries Allen Company Books Bond investment—Locust Sales Company ……… 20,850 Cash …………………………………………….. 20,850 Cash …………………………………………………. 700 Bond Investment—Locust Sales Company … 85 Interest Revenue ………………………………. 615 Locust Sales Company Books Cash ………………………………………………….. 20,850 Bonds Payable …………………………………. 20,000 Premium on Bonds Payable ………………….. 850 Interest Expense ……………………………………. 615 Premium on Bonds Payable ………………………. 85 Cash …………………………………………….. 700

9. Amortization Table—Straight Line

10. Amortization Table—Straight Line

11. Amortization Table—Straight Line

12. Effective-Interest Method • Under the effective interest method, the amount of the premium amortized each period will be different. • The amortization amount will be less in the early periods and greater in the later periods over the life of the bonds. • The amortization computation in each period will be made using the effective interest rate. In this example, Allen Company bought the bonds to yield approximately 6% annually (or 3% every 6 months). • The computations are illustrated in the table on the next slide.

13. Effective-Interest Method

14. Effective-Interest Method

15. Effective-Interest Method

16. Effective-Interest Method * Adjusted for rounding.

17. Effective-Interest Method Allen Company Books Bond investment—Locust Sales Company ……… 20,850 Cash ……………………………………………… 20,850

18. Effective-Interest Method Allen Company Books Bond investment—Locust Sales Company ……… 20,850 Cash ……………………………………………… 20,850 Cash …………………………………………………. 700 Bond Investment—Locust Sales Company ….. 74 Interest Revenue ………………………………… 626

19. Effective-Interest Method Allen Company Books Bond investment—Locust Sales Company ……… 20,850 Cash ……………………………………………… 20,850 Cash …………………………………………………. 700 Bond Investment—Locust Sales Company ….. 74 Interest Revenue ………………………………… 626 Cash ………………………………………………….. 700 Bond Investment—Locust Sales Company …... 77 Interest Revenue ………………………………… 623

20. Effective-Interest Method Locust Sales Company Books Cash …………………………………………………. 20,850 Bonds Payable ………………………………….. 20,000 Premium on Bonds Payable …………………… 850

21. Effective-Interest Method Locust Sales Company Books Cash …………………………………………………. 20,850 Bonds Payable ………………………………….. 20,000 Premium on Bonds Payable …………………… 850 Interest Expense ……………………………………. 626 Premium on Bonds Payable ………………………. 74 Cash ……………………………………………… 700

22. Effective-Interest Method Locust Sales Company Books Cash …………………………………………………. 20,850 Bonds Payable ………………………………….. 20,000 Premium on Bonds Payable …………………… 850 Interest Expense ……………………………………. 626 Premium on Bonds Payable ………………………. 74 Cash ……………………………………………… 700 Interest Expense ……………………………………. 623 Premium on Bonds Payable ………………………. 77 Cash ……………………………………………… 700

23. End of Problem