10-1

Amortization of Premiums:Straight-Line Method

Effective-Interest Method

Chapter 10Illustrated Solution: Problem 10-35Illustrated Solution: Problem 10-35

10-2

General Concerns with BondsGeneral 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.

10-3

Problem BackgroundProblem 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%).

10-4

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?

Premium on Bonds—The ConceptPremium on Bonds—The Concept

10-5

Straight-Line MethodStraight-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

10-6

Straight-Line MethodStraight-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.

10-7

Straight-Line EntriesStraight-Line Entries

Allen Company Books

Bond investment—Locust Sales Company……… 20,850Cash…………………………………………….. 20,850

Cash…………………………………………………. 700Bond Investment—Locust Sales Company… 85Interest Revenue………………………………. 615

10-8

Straight-Line EntriesStraight-Line Entries

Allen Company Books

Bond investment—Locust Sales Company……… 20,850Cash…………………………………………….. 20,850

Cash…………………………………………………. 700Bond Investment—Locust Sales Company… 85Interest Revenue………………………………. 615

Locust Sales Company Books

Cash………………………………………………….. 20,850Bonds Payable…………………………………. 20,000Premium on Bonds Payable………………….. 850

Interest Expense……………………………………. 615Premium on Bonds Payable………………………. 85

Cash…………………………………………….. 700

10-9

Amortization Table—Straight LineAmortization Table—Straight Line

Interest Payment

A B C Interest

Received (3½% of

Face Value)

Premium Amortization ($850 x 1/10)

Interest Revenue (A – B)

1 700 85 6152 700 85 6153 700 85 6154 700 85 6155 700 85 6156 700 85 6157 700 85 6158 700 85 6159 700 85 615

10 700 85 615

10-10

Amortization Table—Straight LineAmortization Table—Straight Line

Interest Payment

A B C DInterest

Received (3½% of

Face Value)

Premium Amortization ($850 x 1/10)

Interest Revenue (A – B)

Unamortized Premium(D – B)$850

1 700 85 615 7652 700 85 615 6803 700 85 615 5954 700 85 615 5105 700 85 615 4256 700 85 615 3407 700 85 615 2558 700 85 615 1709 700 85 615 85

10 700 85 615 0

10-11

Amortization Table—Straight LineAmortization Table—Straight Line

Interest Payment

A B C D EInterest

Received (3½% of

Face Value)

Premium Amortization ($850 x 1/10)

Interest Revenue (A – B)

Unamortized Premium(D – B)

Bond Carrying

Value(E – B)

$850 $20,8501 700 85 615 765 20,7652 700 85 615 680 20,6803 700 85 615 595 20,5954 700 85 615 510 20,5105 700 85 615 425 20,4256 700 85 615 340 20,3407 700 85 615 255 20,2558 700 85 615 170 20,1709 700 85 615 85 20,085

10 700 85 615 0 20,000

10-12

Effective-Interest MethodEffective-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.

10-13

Effective-Interest MethodEffective-Interest Method

Interest Payment

A B C D EInterest

Received (3½% of Face

Value)

Interest Revenue(3% of Bond

Carrying Value)

Premium Amortization

(A – B)

Unamortized Premium(D – C)

BondCarrying

Value(E – C)

$850 $20,850

10-14

Effective-Interest MethodEffective-Interest Method

Interest Payment

A B C D EInterest

Received (3½% of Face

Value)

Interest Revenue(3% of Bond

Carrying Value)

Premium Amortization

(A – B)

Unamortized Premium(D – C)

BondCarrying

Value(E – C)

$850 $20,850

1 $700 $626 (.03 x $20,850) $74 766 20,766

10-15

Effective-Interest MethodEffective-Interest Method

Interest Payment

A B C D EInterest

Received (3½% of Face

Value)

Interest Revenue(3% of Bond

Carrying Value)

Premium Amortization

(A – B)

Unamortized Premium(D – C)

BondCarrying

Value(E – C)

$850 $20,850

1 $700 $626 (.03 x $20,850) $74 766 20,766

2 700 $623 (.03 x $20,776) 77 699 20,699

10-16

Effective-Interest MethodEffective-Interest Method

Interest Payment

A B C D EInterest

Received (3½% of Face

Value)

Interest Revenue(3% of Bond

Carrying Value)

Premium Amortization

(A – B)

Unamortized Premium(D – C)

BondCarrying

Value(E – C)

$850 $20,850

1 $700 $626 (.03 x $20,850) $74 776 20,776

2 700 $623 (.03 x $20,776) 77 699 20,699

3 700 $621 (.03 x $20,699) 79 620 20,620

4 700 $619 (.03 x $20,620) 81 539 20,539

5 700 $616 (.03 x $20,539) 84 455 20,455

6 700 $614 (.03 x $20,455) 86 369 20,369

7 700 $611 (.03 x $20,369) 89 280 20,280

8 700 $608 (.03 x $20,280) 92 188 20,188

9 700 $606 (.03 x $20,188) 94 94 20,094

10 700 $606 ($700 - $94)* 94 0 20,000

* Adjusted for rounding.

10-17

Allen Company Books

Bond investment—Locust Sales Company……… 20,850Cash……………………………………………… 20,850

Effective-Interest MethodEffective-Interest Method

10-18

Allen Company Books

Bond investment—Locust Sales Company……… 20,850Cash……………………………………………… 20,850

Cash…………………………………………………. 700Bond Investment—Locust Sales Company….. 74Interest Revenue………………………………… 626

Effective-Interest MethodEffective-Interest Method

10-19

Allen Company Books

Bond investment—Locust Sales Company……… 20,850Cash……………………………………………… 20,850

Cash…………………………………………………. 700Bond Investment—Locust Sales Company….. 74Interest Revenue………………………………… 626

Cash………………………………………………….. 700Bond Investment—Locust Sales Company…... 77Interest Revenue………………………………… 623

Effective-Interest MethodEffective-Interest Method

10-20

Locust Sales Company Books

Cash…………………………………………………. 20,850Bonds Payable………………………………….. 20,000Premium on Bonds Payable…………………… 850

Effective-Interest MethodEffective-Interest Method

10-21

Locust Sales Company Books

Cash…………………………………………………. 20,850Bonds Payable………………………………….. 20,000Premium on Bonds Payable…………………… 850

Interest Expense……………………………………. 626Premium on Bonds Payable………………………. 74

Cash……………………………………………… 700

Effective-Interest MethodEffective-Interest Method

10-22

Locust Sales Company Books

Cash…………………………………………………. 20,850Bonds Payable………………………………….. 20,000Premium on Bonds Payable…………………… 850

Interest Expense……………………………………. 626Premium on Bonds Payable………………………. 74

Cash……………………………………………… 700

Interest Expense……………………………………. 623Premium on Bonds Payable………………………. 77

Cash……………………………………………… 700

Effective-Interest MethodEffective-Interest Method

10-23

End of ProblemEnd of Problem