10-1 amortization of premiums: straight-line method effective-interest method chapter 10 illustrated...
TRANSCRIPT
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