If Schultz issued 100 of its bonds at par, the following entries would be required, and probably require no additional explanation:

1-1-x1

Cash

100,000

Bonds Payable

100,000

To record issuance of 100,8%, 5-year bonds at par (100 X $1,000 each)

periodically

Interest Expense

4,000

Cash

4,000

To record interest payment (this entry occurs on every interest payment date at 6 month intervals $100,000X8%X6/12)

12-31-x5

Bonds Payable

100,000

Cash

100,000

To record payment of face value at maturity

Bond Issued at Premium

You will likely need to reread this paragraph several times before it really starts to sink in. One very simple way to consider bonds issued at a premium is to reduce accounting to its simplest logic - -counting money! If Schultz issues 100 of the 8%, 5-year bonds when the market rate of interest is only 6%, then the cash received is $108,530 (see the previous discussion for the related calculations). Schultz will have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). Thus, Schultz will repay $31,470 more than was borrowed ($140,000 -$108,530). This $31,470 must be expensed over the life of the bond; uniformly spreading the $31,470 over 10 six month periods produces periodic interest expense of $3,147 (do not confuse this amount with the cash payment of $4,000 that must be paid every six months!). Another way to consider this problem is to note that total borrowing cost is reduced by the $8,530 premium, since less is to be repaid at maturity than was borrowed up front. Therefore, the $4,000 periodic interest payment is reduced by $853 of premium amortization each period ($8,530 premium amortized on a straight line basis over the 10 periods), producing the periodic interest expense of $3,147 ($4,000 - $853)!

This topic is inherently confusing, and the journal entries are actually helpful in clarifying your understanding. As you look at these entries, notice that the premium on bonds payable is carried in a separate account (unlike accounting for investments in bonds covered in a prior chapter, where the premium was simply included with the Investment in Bonds account).

1-1-x1

Cash

108,530

Premium on Bonds Payable

8,530

Bonds Payable

100,000

To record issuance of 100,8%, 5-year bonds at premium

periodically

Interest Expense

3,147

Premium on Bonds Payable

853

Cash

4,000

To record interest payment (this entry occurs on every interest payment date at 6 month intervals) and amortization of premium

12-31-x5

Bonds Payable

100,000

Cash

100,000

To record payment of face value at maturity

By carefully studying the following illustration you will observe that the Premium on Bonds Payable is established at $8,530, then reduced by $853 every interest date, bringing the final balance to zero at maturity.

Period Ending

Bonds Payable

Unamortized Premium

Net Book Value

(Bonds Payable plus Unamortized Premium)

Interest Expense

(Cash Paid less Premium Amortization)

$ 100,000

$ 8,530

$ 108,530

6-30-x1

100,000

7,677 107,677

$ 3,147

12-31-x1

100,000

6,824

106,824

3,147

6-30-x2

100,000

5,971 105,971

3,147

12-31-x2

100,000

5,118

105,118

3,147

6-30-x3

100,000

4,265 104,265

3,147

12-31-x3

100,000

3,412

103,412

3,147

6-30-x4

100,000

2,559 102,559

3,147

12-31-x4

100,000

1,706

101,706

3,147

6-30-x5

100,000

853 100,853

3,147

12-31-x5

100,000

0

100,000

3,147

On any given financial statement date, Bonds Payable is reported on the balance sheet as a liability, along with the unamortized Premium appended thereto (known as an "adjunct" account). To illustrate, the balance sheet disclosure as of 12-31-X3 would appear as follows:

Long-term Liabilities

Bonds payable

Plus: Unamortized premium on bonds payable

$ 100,000 3,412

$ 103,412

The income statement for all of 20X3 would include $6,294 of interest expense ($3,147 X 2). This method of accounting for bonds issued at a premium is known as the straight-line amortization method, as interest expense is recognized uniformly over the life of the bond. The technique offers the benefit of simplicity, but it does have one conceptual shortcoming. Notice that interest expense is the same each year, even though the net book value of the bond (bond plus remaining premium) is declining each year due to amortization. As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) that was implicit in the pricing of the bonds. For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4, interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412). Accountants have devised a more precise approach to account for bond issues called the effective interest method. Be aware that the more theoretically correct effective interest method is actually the required method, except in those cases where the straight-line results do not differ materially. Effective-interest techniques are introduced in a following section of this chapter

Bond Issued at a Discount

If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10% -see the previous discussion for exact calculations), Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). Thus, Schultz will repay $47,722 ($140,000 - $92,278) more than was borrowed. This $47,722 must be expensed over the life of the bond; spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20 (do not confuse this amount with the cash payment of $4,000 that must be paid every six months!). Another way to consider this problem is to note that the total borrowing cost is increased by the $7,722 discount, since more is to be repaid at maturity than was borrowed upfront. Therefore, the $4,000 periodic interest payment is increased by $772.20 of discount amortization each period ($7,722 discount amortized on a straight line basis over the 10 periods), producing periodic interest expense that totals $4,772.20!

Now, let's look at the entries for the bonds issued at a discount. Like bond premiums, discounts are also carried in a separate account.

1-1-x1

Cash

92,278

Discount on Bonds Payable

7,722

Bonds Payable

100,000

To record issuance of 100,8%, 5-year bonds at

discount

periodically

Interest Expense

4,772

Discount on Bonds Payable

772

Cash

4,000

To record interest payment (this entry occurs

on every interest payment date at 6 month

intervals) and amortization of discount

12-31-x5

Bonds Payable

100,000

Cash

100,000

To record payment of face value at maturity

By carefully studying this illustration, you will observe that the Discount on Bonds Payable is established at $7,722, then reduced by $772.20 on every interest date, bringing the final balance to zero at maturity. On any given financial statement date, Bonds Payable is reported on the balance sheet as a liability, along with the unamortized Discount that is subtracted (known as a "contra" account). The illustration below shows the balance sheet disclosure as of June 30, 20X3. Note that the unamortized discount on this date is determined by calculations revealed in the table that follows:

Long-term Liabilities

Bonds payable

Less: Unamortized discount on bonds payable

$ 100,000 (3,861)

$ 96,139

Period Ending

Bonds Payable

Unamortized Discount

Net Book Value

(Bonds Payable less Unamortized Discount)

Interest Expense (Cash Paid plus Discount Amortization)

$ 100,000.00

$ 7,722.00

$ 92,278.00

6-30-x1

100,000.00

6,949.80

93,050.20

$ 4,772.20

12-31-x1

100,000.00

6,177.60

93,822.40

4,772.20

6-30-x2

100,000.00

5,405.40

94,594.60

4,772.20

12-31-x2

100,000.00

4,633.20

95,366.80

4,772.20

6-30-x3

100,000.00

3,861.00

96,139.00

4,772.20

12-31-x3

100,000.00

3,088.80

96,911.20

4,772.20

6-30-x4

100,000.00

2,316.60

97,683.40

4,772.20

12-31-x4

100,000.00

1,544.40

98,455.60

4,772.20

6-30-x5

100,000.00

772.20

99,227.80

4,772.20

12-31-x5

100,000.00

0

100,000.00

4,772.20

The income statement for each year would include $9,544.40 of interest expense ($4,772.20 X 2) under this straight-line approach. It again suffers from the same theoretical limitations that were discussed for the straight-line premium example. But, it is an acceptable approach if the results are not materially different from those that would result with the effective-interest amortization technique.

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