 In this presentation we will discuss the amortization of a bond premium and the recording of interest expense on bonds. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical reasonable fashion making it much more easy to find what you need then can be done on a YouTube page. We also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable. So once again click the link below for a free month membership to our website and all the content on it. 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 up Mount 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. However 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. Note 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 often times 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 $241,000 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 2 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 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 equal 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 or 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 2 that's going to be the 9600 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 state 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 months rate we could say every six months is half a year or take that and divide it by 2.04 must 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 gonna have to reduce here we had 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 that's a credit we need to make it go down so we're gonna do the opposite thing to it to decrease it so we're just gonna kind of like plug this in there into our journal entry so I know that the cash is gonna be paid here and I know we're gonna 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 an 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 gonna say that the bond interest expense is gonna go from zero up by 8,600 to 8,600 the cash is gonna go from 990,000 down by 9,600 because we're paying the interest and then the premium is gonna 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 gonna 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 gonna 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 gonna be the same transaction we're gonna say cash is gonna go down by that 9,600 which is calculated in terms of our the amount we're actually gonna pay face amount 240,000 times the yearly rate 0.08 the rate on the bond not the market rate and then we're gonna take that would be a year divided by two because it's semi-annual so that's what we're actually gonna pay for cash we're gonna reduce the premium by the 1000 just like we were gonna it's just like if it was equipment that we're amortizing and then the difference of course is gonna go to the bond interest expense so if we go through that again we're gonna say that the bond interest is gonna 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