 Hello and welcome to the session in which we would look at the effective interest amortization method. This topic is important whether you are taking the CPA exam or you are an accounting student. Financial accounting, intermediate accounting, the CPA exam far, they all cover this effective interest amortization method. The amortization method will help you find the book value or the carrying value of the bond. That's important because when you retire a bond, you need to determine whether they have a gain or a loss. So it's important to do that. So whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. You keep your CPA review course. I'm a useful addition to your CPA review course. I add value. I add knowledge, which in turn will help you prepare for your CPA exam. Your risk is one month of subscription. My material is organized to align with your CPA review course, so it's easy to follow. Your potential return is passed in the exam. And if not for anything, take a look at my website to find out how well or not well your University of the Wing on the CPA exam. I do have resources for other accounting courses. This is my course catalog, various accounting courses, intermediate, financial, advanced, tax, cost. My CPA review courses are designed to align with your CPA review course, whether it's Becker, Roger, Gleam, Wiley, and I do have all the previously AI CPA release questions for the past 10 years. The multiple choice section. If you have not connected with me on LinkedIn, please do so. Like this recording, take a look at my LinkedIn recommendation. Connect with me on Instagram, Facebook, Twitter, and Reddit. So the effective interest rate method is very important and very common on the CPA exam. So let's take a look at an example to illustrate this concept. Okay. Now, on December 31st, 2022, Adam Company issues a $100,000 power value bond, a two-year bond for 96.4 to yield 10.031. The stated rate is 8%. The bond pays interest on June 30th and December 31st. First, let's make sure we understand what we are giving. Adam Company tried to raise money. They wanted to borrow $100,000. They're offering 8% interest semi-annually. They sold the bond, which is the price of the sale at a discount at 96.4. Now, if you don't know how we compute this price, 96.4, I have a separate recording how to price a bond. But in this session, I'm going to assume you know it. Even if you don't know it, you don't have to know it. But if you want to know it, view my how to compute the price of a bond. The bond to yield 10.03%. That means this is the market rate for similar bonds. And that's why the bonds sold at a discount because they're offering 8 and the market is 10.03. Let's real quick go ahead and journalize this entry. The company would receive cash of $96,400. And that's taking the face value of the bond times the price, 96.4%. The company will credit bonds payable for $100,000. You will always credit and debit the bonds payable for face value. And as I told you, there's a discount. And the discount is the difference of $3,600. Now, this is the amount that we need to take care of to amortize this discount. What is a discount? Discount is a counter-liability. Discount is the interest that the company kind of paid up front, OK? Because they could not get the $100,000, they paid a discount in a sense that they get less money. So rather than getting $100,000, notice they got $96,400. So the difference is that kind of prepayment of interest. But we cannot call it interest. We're going to call it discount and we're going to amortize it. Spread it out over the life of the bond. So every time we make an interest payment, we're going to chop some of that payment, some of that $3,600, chop it in a sense, turn it into an expense, specifically interest expense. Now, there's two methods to do that. You can take this $3,600 and spread it over four period. And the reason I say over four period because it's a two-year bond paying interest summa annually, which is four periods. That's one way to do it. Or we can charge the interest, which is the proper way, using the effective interest rate method, the method that we will see today. What does that mean? It's based on the carrying value of the bond. So let's take a look at this, what we just said and try to illustrate this because it will be easier to explain. So when we start the bond, when we issued the bond, the bond carrying value is $96,400. So what is the bond carrying value? The bond carrying value is the face value minus any un-amortized discount. So when we issued the bond, we had un-amortized discount of $3,600. Therefore, the bond carrying value is $96,400. And this is when we issued the bond. Now notice we have a column for cash interest paid, column for bond interest expense, column for discount amortization, column for the un-amortized discount, and column for the carrying value. So I'll explain what goes into each column separately. And then you'll be fine. You'll be fine. Okay, the first thing we're gonna do, we're gonna compute, show you how to compute the cash interest paid. So six months later, we're gonna have to make a payment. Well, the cash interest paid is the face value of the bond times the stated rate times one-half. Why one-half? Because the bond pays interest summa annually, and that's equal to 4,000. This is the cash payment. The cash payment, so the company will have to pay 4,000. Now this 4,000, you'll see it would repeat over the next four periods. So the cash payment will never change. That's easy. Now we need to compute our bond interest expense. How do we compute the bond interest expense? We're gonna take the carrying value of the bond, which is the carrying value of the bond at the beginning of the period is 96,400, multiplied by the market rate, by the market rate, 10.031%, also times one-half because we're converting everything one-half, and that's gonna give us 835. And that's you, I'm sorry, 4,835. And that's your bond interest expense. So notice your bond interest expense is higher than your cash. Your bond interest expense is 835,000 higher than your cash. You might be asking, does that make sense? And the answer is, yes, it will make sense. Remember what I told you at the beginning. I told you that this 3,600, it's gonna turn into interest expense. So this 3,600, I'm now converting some of it into interest expense. How much did I convert? The difference between what I paid in cash and what my bond interest expense is, so the difference between those two is 835. This is how much I converted this period. Therefore, my interest expense is my $4,000 in cash plus the 835 of discount. So 4,835. Now, what I'm gonna do, I'm gonna keep track of my unamortized amount. So if I had 3,600, I deducted from it 8,835. What's left is 2,765. Now my carrying value will go up. Why am I carrying value will go up? Because now my face value is still 100,000. My unamortized is 2,765. Therefore, my book value is 97 to 35. Okay, so this is where all these figures are coming from. Now let me show you now the journal entry for the interest. The journal entry is the old debit bond interest expense 4,835, credit my cash 4,000, credit my discount 835. So simply put, my interest expense is 4,000 in cash, 835 in discount, together give me 4,385, okay. Now let's take a look at six month later. Six month later, the same thing will happen. Cash will stay the same. My interest expense is my previous period, bond carrying value times 10.013 times 1.5. The difference between those two is the amount I amortize. Then the unamortized discount, now it goes down to 1,887 because I reduced it by 877. My carrying value goes up to 98,112 because I have less of unamortized discount. So notice here, what I want to show you is your interest expense went up. Your interest expense went up. You might be asking, does that make sense and why? And the answer, yes, it makes sense. Why? Because your carry, your interest expense is a function of your carrying value. Your carrying value also going up went from 96,400 to 97,235. Therefore, your interest expense goes up because you're computing your interest expense based on the carrying value. The third payment, June 30th, 2024. The cash is the same. Your bond interest expense again went up. You took 98,112 times 10.031 times 1.5. The difference between the cash and the interest expense is the amount that you amortize. Therefore, you would reduce 1888 by 921. We'll give you 967. Again, your discount and the carrying amount goes up because your amortized discount is going down. And you make the last payment. Again, the same concept. Eventually, the key is to get root of the unamortized discount. And eventually, when the bond mature, which is 1231, 2024, this is when we, the bond mature, it will go back to the carry, to the power value, or to the maturity value. So this is how we amortize a discounted bond. This is how we amortize a discounted bond. A few things I want you to take away from this table. The cash is always the same. Bond interest expense goes up, okay? An amortized discount, of course, goes down to zero. And bond carrying value goes up. Goes up means, I know I'm looking at this. I'm putting the arrow up, but it goes up in a sense it goes up to the maturity value. It was at 96,400, it went up to 100,000. You have to get rid of the discount. And the bond interest expense goes up every period. Okay, in other words, you are amortizing more every period. Now let's take a look at a premium bond. On December 31st, Aram Company issued 100,000 power value bond for 103.06 premium bond to yield 9.9702. The stated rate is 12%. We're offering more than the market rate. We're gonna sell the bond at a premium. So we're gonna debit cash 103,600. We're gonna credit the bonds payable at face value. And the difference is a premium of 3,600. Same concept. Now we're gonna take this premium and amortize it against interest expense. So the premium reduces your interest expense. In the prior example, when we looked at the bond discount, we said the discount increases your interest expense. The premium is exactly the opposite because you received more money upfront. The premium, it's gonna reduce your interest expense. How are we gonna amortize this? Let's start with the same concept. Carrying value, what's the carrying value? It's the face value plus, plus, not minus, plus any unamortized discounts would happen to be 3,600. Therefore, you're starting a carrying value of 103,600. Now you're gonna make the first payment. The first payment is 6,000 and the payment will always stay the same, which is your face value times stated rate times one half, which is 6,000. So you could just, on the CPA exam, once you know the cash payment, fill out the cash payment so you get your points for that. Same concept for computing your bond interest expense. It's your carrying value from the previous period or at the beginning of the period times the market rate, which is 103,600 times 0.099702 will give us 5,165. Notice, your interest expense is lower than your cash. Why? Because the premium reduces your interest expense because you received more money upfront. It's gonna reduce your interest expense. The difference between those two gives you the premium amortized. Now since you amortized 835, you're gonna reduce it from 3,600. You're gonna have 2750 left. Your carrying value goes down because in a premium bond, it's above face value. It's gonna go down to face value. The journal entry is debit bond interest expense, 5165 credit cash. Notice you paid more than interest expense. You paid more than interest expense. Your interest expense is lower than you start to amortize the premium. Then the same concept would repeat itself. The cash is the same, interest expense is the carrying value times the market rate. The difference is the premium amortize. Then your amortized premium goes down and your carrying value goes down. Then the process repeat itself and as a result, what's gonna happen? Again, your bond carrying value goes down to 100,000. Your interest expense period after period goes down. Why? Because your bond carrying value is going down. This stays the same. And eventually your premium goes down to zero. So this is how we amortize a premium bond. At the end of this recording, I'm gonna remind you whether you are an accounting student or a CPA candidate. Take a look at my material. If you're interested in investing in your career, in your CPA, in your accounting courses. I don't replace your CPA review course. I'm a supplemental material. I can help you improve your grade to pass the exam, to move on with your life, to have a career. Good luck, study hard, stay safe. Accounting is worth it.