 In this presentation we will discuss the amortization of a bond premium and the recording of interest expense on bonds. This is going to be our starting point. This is the initial transaction in order to get the bonds on the books. Here's our data down here. We've got the number of years. We've got the face amount of the bonds. We've got the issue price 270. We see that the interest on the market rate is different than the contract rate. The result then is that cash is going to be increased by the 270. The bonds payable went on the books for the face amount of the bond, the amount that's on the bonds of the 240 which is a liability. And then we have the premium being the difference increasing the premium here by the 30. The 240 plus the 30 is going to be equal to the 270,000 carrying amount book value of the bonds. Now we're going to go through the process of recording the interest. We can see that this is going to have 15 year bonds. We're going to pay the bonds semi annually. So we're going to have to record the interest on them and we're going to have to reduce this premium in some way as well. Remember at the end of the bonds we're not going to pay back the 270. We're only going to pay back 240. So how are we going to get rid of that the premium on the bond and why are we going to do it in the way we will. We'll start off by amortizing the premium using a straight line method. Note that the effective method is the preferred method for amortizing a premium for generally accepted accounting principles. But the straight line method will be appropriate in some cases if the difference is going to be a not material and the straight line method is a simplified method and it's easy for us to see what is going on. So we'll start off with the straight line method. Later we'll talk about the effective method. Note what is happening here is we have the premium was a result in essence of this difference between the interest rates. Now in many problems this is hard to really understand because oftentimes what's given to us when we record this initial transaction is the face amount being different than the price we receive resulting in the premium when we make the journal entry. But we will do the calculation which is a bit more complex to see what that difference is why does this happen how would we actually negotiate the issue price being different from the face amount and the cause of it of course is the fact that the market rate is different from the contract rate. So in essence then this premium is a result of interest. It's really an interest difference here. We need to get rid of it throughout the life of the loan. We're not going to pay it back at the end of the loan. What we're going to do is reduce it throughout the loan at the same point in times that we make interest payments which in this case is semi annually or two times a year. So we're going to allocate this interest out to interest expense during that time period because it really is kind of a result of the of the interest rates being different. So we're going to allocate it out to the income statement account interest expense as we go. You can think of this as being similar to depreciation because we're going to amortize it and that's why the straight line method is a nice place to start. So remember when we have depreciation on equipment what we typically do for the simplified easy method to allocate the cost of equipment is to take the cost of equipment divided by the number of periods typically the number of years or months and allocate the cost over that time period. Same thing we're going to do here. We're just going to take this premium and allocate it over the time period 15 years but semi annual payments. So for example on January 1st when we start we've got the premium of 30,000. That means that the carrying value is the 270,000 which is the 240 went on the books for plus the 30,000. That's what's currently a liability on the books as of the beginning of this process. We're going to pay the interest on this bond semi monthly. Now here we're not calculating the amount we're going to pay. We're going to calculate the amount that we're going to allocate of the premium. So of the premium we have 30,000 here 30,000 and we're just going to divide this by not 15 but 30 because we're going to there's going to be 30 time periods meaning we have 15 years semi annually twice a year. So we're going to take that and divide by 30 time periods. The other way you can think about it is if you had the premium of 30,000 divided by the number of years 15 it would be 2,000 and then it's twice a year divided by 2 or 1,000. So that means that we're going to take this premium and we're going to reduce it by 1,000 each time period for 30 time periods which is 15 years times two semi semi annual pay periods times 15 years and then at the end of that then we'll reduce down to zero. So we're going to have 1,000 it's going to take the unamortized premium from 30 down by 1,000 to 29,000 carrying value now is going to be the 240,000 plus the 29,000 and then we're going to just keep doing this process the next the next time period that we pay six months later another 1,000 it's going to be straight so notice we're using straight line so the amount amortized will be the same 29,000 minus the 28,000 and that leads us with the carrying value which again goes down by the 1,000 which is now the 240,000 bond payable plus the bond premium of the 28,000. Now we're going to record our journal entry to record the interest and to record the reduction of the premium on the bonds we will record it here we're going to post it to our trial balance our trial balance is currently in balance because the debits are non bracketed credits are bracketed debits minus the credits equals zero currently net income of 700,000 which is the sales of 700 no expenses at this time when we calculate the interest remember that we have 15 years bonds here we're going to pay the interest at the contract rate of 8% how much that's how much cash is actually going to be leaving the company so that's where we should start we're going to say well cash is affected cash is a debit balance we're going to make it go down so we know that's going to be the case question is how much will it go down by we're going to take the face amount not the issue price the face amount we're talking about what's actually physically on the bond here that's the promise that's on the bond which is the 240,000 and then the amount of the interest rates that are on the bond is the one on the bond of the contract rate not the market rate so we're going to take this times 0.08 that's the actual contract that's the actual bond the 19-2 is what we would pay if it was paid each year then we're going to take that and divide it by two that's going to be the 9,600 so this is how I would think of the interest rate now there's a couple different ways you can think of that calculation I typically think of it of the the face amount the amount of bond 240,000 multiplied times the rate on the bond which note that remember any rate is really a yearly rate unless stated otherwise so if we say something's 8% we usually mean 8% a year your mortgage rate if we say 8% we mean 8% a year so if I multiply this times 0.08 8% I'm going to get 19-2 which is 19-2 how much interest we would pay in a year it's only six months so we could break it down to a monthly total we could do that by saying divided by 12 1,600 a month times six months or we could just divide it by two note the other way you can do it which is useful for excel is to say okay well if 0.08 is the yearly rate what's the six month's rate we could say every six months is half a year or take that and divide it by 2.04 months be the monthly rate times the 240,000 to give us that same amount so a couple different ways to think about it just get an idea and remember to know what the interest rate means it means for a year typically now the bond premium that we're going to have to reduce here we already calculated on our amortization table 1,000 per time period meaning it's on the books as a credit and we have to know that and it's helpful to know that if we have a trial balance because we can see hmm it's a credit we need to make it go down so we're going to do the opposite thing to it to decrease it so we're just going to kind of like plug this in there into our journal entry so I know that the cash is going to be paid here and I know we're going to reduce the premium to kind of straight line it down to zero towards the end and then the difference then is going to be the interest which will be the 9,006 minus the 1,000 or the debit that we need in order to finish this process so note that the debits here are not in order debits and then credits I kind of built this in in order to be able to see how things are going to be put together so you could rearrange it to put the debits on top or you can keep it like this it's not quite as proper but whatever way helps you to see how the thing was constructed that's the way I would put it together so note what happened here is the interest expense is only 8,600 even though we're paying cash which is interest on the bond of 9,600 why because the difference between those two is really in essence bringing the interest rate that's on the bond down to the market rate because we're not really paying 8% on the 240,000 because we really got 270,000 and we're only paying interest on the 240,000 so that difference is what we're trying to account for as we as we kind of net out this interest payment if we record this then we're going to say that the bond interest expense is going to go from zero up by 8,600 to 8,600 the cash is going to go from 990,000 down by 9600 because we're paying the interest and then the premium is going to go from 30,000 down by that 1,000 to 29,000 that now matching our unamortized premium amount on our amortization table if we take this amount and this amount that's going to match our carrying amount per the amortization the effect here on net income of course is to decrease net income by the expense the expense being lower in this case than the actual cash we paid because of the reduction of the premium which is a result of the differences in interest rates market versus contract rate if we do this again we're just going to jump forward in time to the next interest payment which is on 12 one another six months later and that's how these bond problems work we typically have to kind of jump forward in time so now we're going to say we record the same thing it's going to be the same transaction we're going to say cash is going to go down by that 9,600 which is calculated in terms of our the amount we're actually going to pay face amount 240,000 times the yearly rate 0.08 the rate on the bond not the market rate and then we're going to take that would be a year divided by two because it's semi-annual so that's what we're actually going to pay for cash we're going to reduce the premium by the 1,000 just like we were going it's just like if it was equipment that we're amortizing and then the difference of course is going to go to the bond interest expense so if we go through that again we're going to say that the bond interest is going to go up again by to 17,200 we've got the cash going down and we've got the premium going down so now the premiums at 28 that should match what's on our table as unamortized and our interest expense has increased which brings net income down