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Over the life of the bonds, the $150,000 premium is to be accounted for as a reduction of the corporation’s interest expense. After the payment is recorded, the carrying value of the bonds payable on the balance sheet increases to $9,408 because the discount has decreased to $592 ($623–$31). Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.
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See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium. At maturity, the General Journal entry to record the principal repayment is shown in the entry that follows Table 4 . 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. See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization .
This increase in bond price above the stated price is referred to as the bond premium. Obviously, an investor wouldn’t want to purchase a bond that produces a lower return than the going market rate and the company wouldn’t want to issue bonds paying higher than market rates of interest. Bond issuers fix this problem by adjusting the issue price of the bond, so the actual interest paid on the bond equals the market rate.
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Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University. Bonds sold at a premiumWhereas the discount on a bond is recorded as additional interest expense, the premium on a bond is recorded as a reduction in interest expense.
- Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented.
- Initially it is the difference between the cash received and the maturity value of the bond.
- This means the interest rates issued and printed on the bonds aren’t the same as the current market rates.
- At the time, the market rate is lower than 8%, so investors pay $1,100 for the bond, rather than its $1,000 face value.
- The net result is a total recognized amount of interest expense over the life of the bond that is greater than the amount of interest actually paid to investors.
Each period the interest expense (4,249) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) less the premium amortized (551). When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. Thus, how to calculate premium on bonds payable interest expense is recorded as $4,324.44 for the first period, while $675.56 is recorded as premium amortization. The actual cash interest paid was only $5, the coupon multiplied by the bond’s face value. However, interest expense also includes the $558.39 of amortized discount in the first six months.
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Assume XYZ Corp. sells $100,000 of five-year bonds with a semiannual coupon of 5%, or 10% per year. Investors think the company is risky, so they demand a 12% yield to maturity for buying these bonds. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis.
The journal entries for the years 2023 through 2026 will be similar if all of the bonds remain outstanding. Beware of internet scams with a picture of this page claiming you can enter your birth certificate number to access bonds owed to you. Repeat this process for each year, using the updated carrying value to calculate the interest expense, until the bond’s carrying value equals its face value at maturity.