Principles of Financial Accounting: Long Term Liabilities - Amortizing Bond, Discount and Premium StraightLine vs. Effective Interest Method

What It Is

Amortizing bond discount and premium is a process of gradually reducing or increasing the carrying value of a bond over its life. This is necessary because bonds are issued at a discount or premium from their face value, and the difference between the issue price and face value must be amortized over the bond's life using either the straight-line method or the effective interest method. For example, if a company issues a $10,000 bond at a 5% discount, the carrying value of the bond would be $9,500, and the discount of $500 would be amortized over the bond's life.

Key Concepts & Formulas

• Straight-Line Method: A method of amortizing bond discount or premium by dividing the discount or premium by the number of years to maturity. Example: If a bond has a $500 discount and a 5-year life, the annual amortization would be $100 ($500 ÷ 5 years).
• Effective Interest Method: A method of amortizing bond discount or premium by calculating the interest on the carrying value of the bond at the end of each period. Example: If a bond has a $500 discount and a 5-year life, the carrying value at the end of the first year would be $9,500, and the interest on this value would be $475 ($9,500 x 5%), which would be used to amortize the discount.
• Carrying Value: The value of a bond after amortizing the discount or premium. Example: If a bond has a face value of $10,000 and a $500 discount, the carrying value would be $9,500.
• Amortization Expense: The expense recognized each period for the amortization of bond discount or premium. Example: If a bond has a $500 discount and a 5-year life, the annual amortization expense would be $100 ($500 ÷ 5 years).
• Bond Discount: The difference between the face value of a bond and its issue price when issued at a discount. Example: If a bond has a face value of $10,000 and is issued at $9,500, the bond discount would be $500.
• Bond Premium: The difference between the face value of a bond and its issue price when issued at a premium. Example: If a bond has a face value of $10,000 and is issued at $10,500, the bond premium would be $500.
• Interest Expense: The expense recognized each period for the interest on the carrying value of the bond. Example: If a bond has a face value of $10,000 and a 5% interest rate, the annual interest expense would be $500 ($10,000 x 5%).

Journal Entry Examples

Straight-Line Method

• Dr. Bond Discount $100
• Cr. Interest Expense $100
• Dr. Bond Discount $100
• Cr. Interest Expense $100 (for each of the 5 years)

Effective Interest Method

• Dr. Bond Discount $475
• Cr. Interest Expense $475
• Dr. Bond Discount $475
• Cr. Interest Expense $475 (for each of the 5 years)

Common Mistakes

• Mistake: Confusing debits and credits for bond discount and premium accounts.
• Correction: Bond discount accounts are debited, and bond premium accounts are credited.
• Mistake: Failing to calculate the carrying value of the bond.
• Correction: The carrying value is calculated by subtracting the bond discount or adding the bond premium from the face value of the bond.
• Mistake: Failing to recognize interest expense for the interest on the carrying value of the bond.
• Correction: Interest expense is recognized each period for the interest on the carrying value of the bond.

Exam Tips

• Tip: Make sure to calculate the carrying value of the bond before amortizing the discount or premium.
• Tip: Recognize interest expense for the interest on the carrying value of the bond.
• Tip: Be careful when using the effective interest method, as it requires calculating the interest on the carrying value of the bond at the end of each period.

Quick Practice

1. A company issues a $10,000 bond at a 5% discount. What is the carrying value of the bond after the first year using the straight-line method? Answer: $9,750 ($10,000 - $250 amortization) Explanation: The bond discount is amortized by $250 each year, so after the first year, the carrying value would be $9,750.
2. A company issues a $10,000 bond at a 5% premium. What is the carrying value of the bond after the first year using the effective interest method? Answer: $10,475 ($10,000 + $475 interest) Explanation: The bond premium is added to the face value of the bond, and the interest on this value is calculated and used to amortize the premium.
3. A company issues a $10,000 bond at a 5% discount. What is the amortization expense for the first year using the straight-line method? Answer: $200 ($500 discount ÷ 5 years) Explanation: The bond discount is amortized by $200 each year, so the amortization expense for the first year would be $200.

Last-Minute Cram Sheet

1. Bond discount is debited, and bond premium is credited.
2. Carrying value = Face value ± Bond discount/Premium.
3. Interest expense = Interest rate x Carrying value.
4. Amortization expense = Bond discount/Premium ÷ Number of years to maturity.
5. Dividends are NOT an expense – they go directly to retained earnings.
6. Interest expense is recognized each period for the interest on the carrying value of the bond.
7. Straight-line method: Amortize bond discount/Premium by equal amounts each period.
8. Effective interest method: Calculate interest on carrying value of bond at end of each period.
9. Carrying value is the value of the bond after amortizing the discount or premium.
10. Amortization expense is the expense recognized each period for the amortization of bond discount or premium.