Note
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Long term liabilities (LO 13.1)
LO 13.1 Here’s the explanation using the Feynman Technique, breaking it down into simple terms:
What Are Bonds?
A bond is a special kind of loan a company takes to raise money. Think of it as borrowing money from a group of people instead of just one person.
Instead of borrowing one big chunk of money (like a note payable), the loan is split into smaller, more manageable pieces. Usually, each piece is worth $1,000. These smaller pieces are sold to multiple investors.
This makes it easier for the company to raise a large amount of money by getting it from many investors instead of just one.
Notes Payable vs. Bonds Payable
Notes Payable:
When a single lender gives money to a company, a note payable is created.
It’s a legal document that includes key details: the loan amount, due date (maturity date), and the interest rate.
Bonds Payable:
A bond works like a note payable but is split into smaller amounts ($1,000 per bond).
This way, a company can get money from several investors instead of just one.
How Bonds Work
When a company issues bonds, it creates a bond contract called a bond indenture. This contract explains:
How much the company will repay when the bond matures (the face value).
The interest rate and how often interest will be paid (usually every six months).
The bond itself is like a certificate promising the investor they’ll get their money back with interest.
Why Use Bonds?
Bonds are used when a company needs a lot of money—too much for one lender to provide.
By splitting the loan into smaller pieces, the company can attract more investors and raise the required funds.
Summary
A note payable is a loan from one lender, while bonds payable are loans split into smaller pieces to attract multiple investors. Bonds are managed through a bond indenture and are a way for companies to raise large sums of money.
Here’s the breakdown using the Feynman Technique, simplifying the types of bonds:
What Are the Different Types of Bonds?
Bonds can be categorized based on their features, how they work, and the risks involved. Let’s explain each type in simple terms:
1. Secured Bonds
What it means: These bonds are backed by something valuable (collateral).
For example, if a company doesn’t pay, the lender can claim the collateral.
Examples:
Mortgage Bonds: Secured by real estate.
Collateral Trust Bonds: Secured by stocks or bonds of other companies.
2. Unsecured Bonds
What it means: These bonds don’t have collateral.
If the company fails to pay, investors have no specific assets to claim.
Types:
Debenture Bonds: Regular unsecured bonds.
Junk Bonds: Unsecured and very risky, but they offer high interest rates to compensate for the risk.
3. Term Bonds
What it means: All these bonds mature (get repaid) on the same day.
Think of it as paying off the full loan in one big payment at the end.
4. Serial Bonds
What it means: These bonds mature in chunks over time.
Useful for organizations like schools or local governments that get money gradually from taxes or fees.
5. Callable Bonds
What it means: The company issuing the bond can “call” (repay) it early before the maturity date.
Companies often do this when interest rates drop—they can borrow money more cheaply elsewhere.
6. Convertible Bonds
What it means: These bonds can be converted into something else, usually common stock (shares of the company).
This gives investors the potential to profit if the company’s stock value goes up.
7. Deep-Discount (Zero-Interest Debenture) Bonds
What it means: These bonds are sold at a big discount instead of paying regular interest.
The investor earns all the interest at the end when the bond matures.
8. Revenue Bonds
What it means: These bonds are paid back using money from specific projects or services.
Commonly issued by airports, toll roads, or schools, where revenue from users is used to pay bondholders.
9. Income Bonds
What it means: These bonds only pay interest if the company issuing them is profitable.
Risky because there’s no guaranteed interest if the company doesn’t make money.
Summary
Bonds come in different forms, depending on how they’re secured, when they mature, or what extra features they offer. Some are safer but pay less (like secured bonds), while others are risky but can offer higher returns (like junk bonds).
Here’s the explanation of the valuation and accounting for bonds payable using the Feynman Technique:
How Are Bonds Valued and Issued?
Issuing bonds isn’t something that happens instantly. It’s a detailed process that takes weeks or even months to complete. Here’s how it works, step by step:
Step 1: Decide to Issue Bonds
What happens?: The company determines it needs to raise money and decides bonds are the best way to do it.
Why?: Bonds let the company borrow money from many investors instead of just one lender.
Step 2: Create a Bond Indenture
What happens?: The company works with lawyers and financial advisors to draft a legal document called a bond indenture.
This document outlines the terms of the bonds: the interest rate, maturity date, and any special features like being callable or convertible.
Step 3: Work with Underwriters
What happens?: The company hires underwriters (investment banks or financial institutions) to help sell the bonds to investors.
Underwriters assess the risk of the bonds and help determine the interest rate that will attract investors.
Step 4: Market the Bonds
What happens?: The company, with help from the underwriters, markets the bonds to the public.
This involves advertising the bonds to potential investors and convincing them to buy.
Step 5: Set the Issue Price
What happens?: The price of the bonds is determined based on:
The interest rate the company is offering (called the stated rate).
Current market interest rates.
The company’s credit rating (how risky it is to lend to them).
If the stated rate is higher than the market rate, the bonds might sell for more than their face value (premium).
If the stated rate is lower than the market rate, they might sell for less than face value (discount).
Step 6: Record the Bond Issuance
What happens?: Once the bonds are sold, the company records the money it receives in its accounting system:
At par value (if the stated and market rates are equal).
At a premium (if the bonds sell for more than face value).
At a discount (if the bonds sell for less than face value).
Step 7: Pay Interest and Record It
What happens?: The company makes regular interest payments to bondholders (usually semiannually).
These payments are recorded as an expense in the company’s accounts.
Step 8: Redeem the Bonds at Maturity
What happens?: When the bonds reach their maturity date, the company repays the face value to the bondholders and records the repayment in its accounts.
Summary
Issuing bonds is a multi-step process involving planning, legal agreements, marketing, pricing, and accounting. Companies must carefully manage each step to raise funds effectively and meet their financial obligations to investors.
Here’s the explanation using the Feynman Technique, breaking down the selling price of a bond and its stated rate into simple terms:
What Affects the Selling Price of a Bond?
When a bond is sold, its price isn’t random. Several factors come into play to determine how much investors are willing to pay for it:
Supply and Demand: Just like any product, the price of a bond depends on how many people want to buy (demand) versus how many bonds are available (supply).
Risk: Investors look at how risky the bond is. Riskier bonds might sell for less unless they offer a higher reward (interest rate).
Market Conditions: The overall financial market can impact bond prices. If the market is unstable, investors might hesitate to buy bonds.
State of the Economy: In a strong economy, investors might prefer riskier investments like stocks, so bond prices might drop. In tough times, bonds become more attractive, and their prices can rise.
Key Term: Stated (Coupon or Nominal) Rate
What is it?: The stated rate is the interest rate written into the bond’s contract (the bond indenture).
Who sets it?: The company issuing the bond decides this rate.
What does it do?: It tells investors how much interest they’ll be paid.
For example, if the bond’s face value is $1,000 and the stated rate is 5%, the bondholder will get $50 per year in interest.
Why Is the Stated Rate Important?
It affects how attractive the bond looks to investors.
If the stated rate is higher than current market interest rates, the bond might sell for more than its face value (at a premium).
If it’s lower than the market rate, the bond might sell for less (at a discount).
Summary
The selling price of a bond depends on factors like market demand, risk, and the economy. The stated rate is the promised interest rate set by the bond issuer and plays a big role in how much investors are willing to pay.
Here’s the explanation using the Feynman Technique, simplifying the concept of the market (or effective) rate and its impact on a bond’s selling price:
What Is the Market (or Effective) Rate?
The market rate (also called the effective rate or effective yield) is the interest rate investors expect to earn on bonds with similar features.
Unlike the stated rate, which is fixed and set by the bond issuer, the market rate changes over time based on external factors.
What Influences the Market Rate?
The market rate isn’t set in stone. It moves up or down depending on several key factors:
Risk of the Company: If a company is seen as risky, investors will demand a higher market rate to compensate for the risk of lending money.
Government Policy: Policies that affect the overall economy, such as taxes or spending programs, can indirectly influence market rates.
Central Bank Interest Rates: When the central bank (like the Federal Reserve) raises or lowers its interest rates, the market rate for bonds adjusts accordingly.
State of the Economy: In a strong economy, market rates might rise as demand for investments grows. In a weak economy, rates might fall as investors look for safer options like bonds.
How Does the Market Rate Impact a Bond’s Price?
The market rate determines how much investors are willing to pay for a bond:
If the Market Rate is Higher Than the Stated Rate:
The bond’s stated interest payments are less attractive compared to other investments.
Investors will only buy the bond if it’s sold for less than its face value (at a discount).
If the Market Rate is Lower Than the Stated Rate:
The bond’s stated interest payments are more attractive compared to other investments.
Investors might pay more than the bond’s face value (at a premium).
Why Does the Market Rate Matter?
The market rate reflects what investors believe is fair for bonds of similar risk and characteristics.
Since it fluctuates over time, it directly impacts the bond’s selling price on the market.
Summary
The market (or effective) rate is the interest rate investors expect based on economic conditions, company risk, and central bank policies. It’s constantly changing, and its relationship to the bond’s stated rate determines whether the bond sells at a discount, at a premium, or at face value.
Here’s the explanation using the Feynman Technique, simplifying how interest rates impact bond prices:
How Do Interest Rates Affect Bond Prices?
The relationship between a bond’s stated rate (the fixed interest rate written in the bond’s contract) and the market rate (the interest rate investors expect) determines whether a bond is sold at a discount, premium, or at face value.
Key Situations to Understand
Let’s look at two examples where the stated rate and market rate are different, and how this impacts the bond price:
Situation 1: Stated Rate (4%) < Market Rate (5%)
What’s happening?:
The bond offers 4% interest, but investors can get 5% elsewhere in the market.
This makes the bond less attractive because it pays less interest than similar investments.
Impact on Price:
The bond will sell for less than $1,000 (at a discount) to make up for its lower interest rate.
Investors will only buy it if they can pay less upfront to still achieve a competitive return.
Situation 2: Stated Rate (4%) > Market Rate (3%)
What’s happening?:
The bond offers 4% interest, while similar investments in the market only offer 3%.
This makes the bond more attractive because it pays higher interest than what’s available elsewhere.
Impact on Price:
The bond will sell for more than $1,000 (at a premium) because investors are willing to pay extra for the higher interest payments.
Why Does This Happen?
Investors compare a bond’s stated interest payments to the returns they could get elsewhere in the market:
If the bond pays less than the market rate, its price drops to compensate for the lower returns.
If the bond pays more than the market rate, its price rises because it’s a better deal.
Summary
The bond price depends on how the stated rate compares to the market rate:
Stated Rate < Market Rate → Bonds sell at a discount (less than $1,000).
Stated Rate > Market Rate → Bonds sell at a premium (more than $1,000). This ensures investors always achieve a return aligned with current market conditions.
Here’s the explanation of bond pricing using the Feynman Technique, broken down into simple steps:
How Is a Bond Priced?
The price of a bond is calculated by finding the present value of its future cash flows. These cash flows include two main parts:
Interest Payments: The bond pays regular interest, calculated based on the bond’s stated rate (also called the coupon rate).
Principal (Face Value): The amount the issuer will pay back to the bondholder at the maturity date (the end of the bond term).
Example: Pricing of Real-Tech’s Bond
Let’s use an example to understand how bond pricing works.
Real-Tech issues $100,000 in bonds with the following features:
Term: 5 years
Interest: 9% annually
Market Rate: 11% (the rate in the market for similar bonds)
QUESTION: What is the price of the bond (the present value of the bond)?
Step 1: Break Down the Cash Flows
Interest Payments: The bond pays 9% interest on $100,000 each year, so:
$100,000 × 9% = $9,000 per year in interest.
Principal Repayment: At the end of 5 years, Real-Tech will pay back the $100,000 face value of the bond.
Step 2: Discount the Cash Flows
To find the present value (price), we need to discount both the interest payments and the principal repayment. The market rate of 11% is used for this calculation because that’s the rate investors expect for similar bonds.
Discounting the Principal (Face Value):
The principal is paid at the end of the 5 years, so we discount it back using the market rate (11%) for 5 periods.
$100,000 × 0.59345 (from the present value table) = $59,345
Discounting the Interest Payments:
The interest is paid annually, so we need to discount 5 payments of $9,000 each at the market rate of 11%.
$9,000 × 3.69590 (from the present value table) = $33,263.10
Step 3: Calculate the Bond Price
Now we add up the present value of the principal and the interest payments to get the bond price (selling price):
$59,345 (principal) + $33,263.10 (interest) = $92,608.10
Step 4: Interpret the Result
The price of the bond is $92,608.10, meaning investors pay this amount to buy the bond.
Since the bond’s price is less than its face value ($100,000), it’s sold at a discount.
The discount is the difference between the face value and the price:
$100,000 – $92,608.10 = $7,391.90.
This discount gives investors extra earnings because they paid less than the face value but will get the full $100,000 when the bond matures.
This results in an effective interest rate of 11%, matching the market rate.
Summary
The price of a bond is calculated by discounting its future interest payments and principal repayment at the market rate. In this example, Real-Tech’s bond is sold at a discount because the market rate (11%) is higher than the stated rate (9%). The bond price reflects the present value of the bond’s cash flows, and the discount gives investors a higher effective yield than the stated rate.
Here’s an explanation of bonds issued at par using the Feynman Technique, breaking it down step by step:
What Happens When Bonds Are Issued at Par?
When a company issues bonds at par, they are sold for their face value. In this case, GreenTea Company is issuing $800,000 in bonds, with a 10-year term and a 10% annual interest rate, payable semiannually. The bonds are issued on January 1, 2025, and the market rate of interest is also 10%, so the bonds are issued at their par value (meaning no discount or premium).
Step 1: Recording the Issuance of the Bonds
When the bonds are issued, GreenTea receives $800,000 in cash, which is the par value of the bonds. The company will record the following entry:
Debit: Cash for $800,000 (this is the money the company receives from selling the bonds)
Credit: Bonds Payable for $800,000 (this is the liability the company now owes to bondholders)
The bonds payable account is always recorded at the face value of the bond, regardless of whether it is issued at a discount, premium, or par.
Step 2: Recording the First Semi-Annual Interest Payment
Since the bond pays interest semiannually and has a 10% annual rate, the interest payment for each 6-month period is:
$800,000 × 10% = $80,000 annual interest
For each semiannual period, divide this amount by 2: $80,000 ÷ 2 = $40,000.
This is the interest payment GreenTea will make every 6 months.
When the first interest payment is made on July 1, 2025, GreenTea will make the following entry:
Debit: Interest Expense for $40,000 (this is the interest expense for the period)
Credit: Cash for $40,000 (this is the payment of interest to bondholders)
Step 3: Accruing Interest at Year-End
On December 31, 2025, GreenTea will need to accrue the interest for the second semiannual period (from July 1 to December 31), even though the payment will be made on January 1, 2026. To do this, GreenTea will make the following entry:
Debit: Interest Expense for $40,000 (this is the interest expense accrued for the second period)
Credit: Interest Payable for $40,000 (this is the liability for the interest that will be paid on January 1, 2026)
Summary
For GreenTea Company’s bond issue:
Issuance of the bonds:
Debit Cash $800,000
Credit Bonds Payable $800,000
First interest payment on July 1, 2025:
Debit Interest Expense $40,000
Credit Cash $40,000
Accrual of interest at year-end (December 31, 2025):
Debit Interest Expense $40,000
Credit Interest Payable $40,000
This reflects the bond issuance, semiannual interest payments, and the accrual of interest at year-end.
Here’s a breakdown of the bond issuance at a discount using the Feynman Technique:
What Happens When Bonds Are Issued at a Discount?
If GreenTea Company issues the bonds at 97 (meaning 97% of the $800,000 par value), the company is issuing the bonds at a discount. So, instead of receiving the full $800,000, they will receive less, which is $776,000 (97% of $800,000).
The company records this transaction by adjusting the cash account to reflect the amount they actually receive and creating a discount on bonds payable account to show the difference between the face value and the amount received. This discount represents extra interest cost to the company over the life of the bond.
Step 1: Recording the Bond Issuance at a Discount
When GreenTea issues the bonds at 97%, the journal entry will look like this:
Debit: Cash for $776,000 (this is the actual cash received from bondholders)
Debit: Discount on Bonds Payable for $24,000 (this is the difference between the par value of $800,000 and the cash received of $776,000)
Credit: Bonds Payable for $800,000 (this is the face value or the amount the company will owe at maturity)
The discount on bonds payable represents a reduction in the bond's carrying value and will be amortized over the life of the bond.
Step 2: Amortizing the Discount
The discount of $24,000 will be amortized over the life of the bond, which is 10 years in this case, and the interest payments are semiannual. This gives us 20 periods (2 periods per year × 10 years).
Using the straight-line method, the same amount of the discount is amortized each period:
$24,000 ÷ 20 periods = $1,200 per period.
This means that $1,200 of the discount will be amortized each period and added to the interest expense.
Step 3: Recording Interest Expense
When it comes time to make semiannual interest payments, GreenTea will still pay interest based on the face value of the bond ($800,000), which is 10% annually. So for each semiannual period:
$800,000 × 10% = $80,000 annual interest
$80,000 ÷ 2 = $40,000 per semiannual payment.
However, because the bonds were issued at a discount, the interest expense will be higher than just the cash payment. The company will add the $1,200 amortization of the discount to the interest expense.
So, the total interest expense for each semiannual period will be:
$40,000 (interest paid) + $1,200 (amortized discount) = $41,200.
Step 4: Journal Entry for Interest Payment
When GreenTea makes the first interest payment on July 1, 2025, they will record the following entry:
Debit: Interest Expense for $41,200 (this is the interest expense, which includes the amortized discount)
Credit: Cash for $40,000 (this is the cash payment of interest)
Credit: Discount on Bonds Payable for $1,200 (this is the amortization of the discount)
Summary
When GreenTea Company issues bonds at a discount (97% of par):
Issuance of Bonds:
Debit Cash $776,000
Debit Discount on Bonds Payable $24,000
Credit Bonds Payable $800,000
Amortizing the Discount:
Straight-line method: Amortize $1,200 each period over 20 periods.
Interest Payment (July 1, 2025):
Debit Interest Expense $41,200 (includes interest paid and amortized discount)
Credit Cash $40,000 (cash paid)
Credit Discount on Bonds Payable $1,200 (amortization of discount)
This process reflects how GreenTea records the bond issuance, interest payments, and discount amortization over time.
Here's a breakdown of straight-line amortization discount for GreenTea's bond issuance using the Feynman Technique:
What Is Straight-Line Amortization for Bond Discount?
When GreenTea issues bonds at a discount, they need to account for the difference between the cash received and the face value of the bonds. The discount is then amortized over the life of the bond using the straight-line method, where the same amount of the discount is recognized as interest expense in each period.
In this case, GreenTea has a $24,000 bond discount on bonds with a $800,000 par value.
Step 1: Semiannual Interest Payment Calculation
GreenTea's bonds have an annual 10% interest rate, so for each semiannual period, the interest paid is calculated as follows:
$800,000 × 10% = $80,000 annual interest.
For each 6-month period, the interest is $80,000 ÷ 2 = $40,000.
This means GreenTea pays $40,000 in interest every six months.
Step 2: Amortizing the Discount
The $24,000 discount is amortized over 20 periods (since the bond has a 10-year term and pays semiannual interest). Using the straight-line method, the discount is divided evenly across all periods:
$24,000 ÷ 20 periods = $1,200 per period.
Each period, $1,200 of the discount is amortized and added to the interest expense.
Step 3: Recording the Interest Payment (July 1, 2025)
When GreenTea makes the first interest payment on July 1, 2025, they need to account for both the cash payment and the amortized discount. Here's the journal entry for this:
Debit: Interest Expense for $41,200 (this is the sum of the $40,000 cash payment plus the $1,200 amortized discount).
Credit: Discount on Bonds Payable for $1,200 (this reduces the discount over the bond's life).
Credit: Cash for $40,000 (this is the cash payment made to bondholders).
Step 4: Recording the Interest Payment (December 31, 2025)
At the end of the year, on December 31, 2025, GreenTea will accrue the same interest expense for the second period. Here's the journal entry for the second interest payment:
Debit: Interest Expense for $41,200 (same as the first payment, including the amortized discount).
Credit: Discount on Bonds Payable for $1,200 (same amortization of the discount).
Credit: Interest Payable for $40,000 (this is the amount the company owes to bondholders, which will be paid in the next period).
Summary
For GreenTea Company, the straight-line amortization for the bond discount involves the following journal entries for the first year:
First Interest Payment (July 1, 2025):
Debit Interest Expense $41,200
Credit Discount on Bonds Payable $1,200
Credit Cash $40,000
Accrual of Interest (December 31, 2025):
Debit Interest Expense $41,200
Credit Discount on Bonds Payable $1,200
Credit Interest Payable $40,000
These entries reflect the interest expense, discount amortization, and interest payments for the first year of the bond term.
Let’s break down the straight-line amortization for bond premium using GreenTea’s bond issuance as an example.
Straight-Line Amortization for Bond Premium
When bonds are issued at a premium, the company receives more cash than the par value because the bond's stated interest rate is higher than the current market rate. This extra cash is called the premium, and it is amortized over the life of the bond.
Step 1: Issuance of Bonds at Premium
In this example, GreenTea Company sells $800,000 in bonds at 103% of par value, meaning they are issued at $824,000. Here’s how the journal entry for the issuance is made:
Debit Cash for $824,000 (this is the amount GreenTea receives for the bonds, which is 103% of the $800,000 par value).
Credit Premium on Bonds Payable for $24,000 (this is the extra cash received above the par value).
Credit Bonds Payable for $800,000 (this represents the face value of the bonds).
Step 2: Recording the Semiannual Interest Payment (July 1, 2025)
The bond pays interest semiannually at a 10% annual rate on the $800,000 par value. The interest expense will be calculated as $800,000 × 10% × 0.5 = $40,000 for each six-month period. However, due to the premium, GreenTea will amortize part of it, reducing the interest expense recognized.
Premium on Bonds Payable = $24,000 ÷ 20 periods (since the bond has a 10-year term and pays semiannual interest), which equals $1,200 per period.
Here’s the journal entry for the semiannual interest payment:
Debit Interest Expense for $38,800 (this is the actual interest expense, which is the cash payment of $40,000 minus the amortization of the premium $1,200).
Debit Premium on Bonds Payable for $1,200 (this is the amount of the premium amortized in this period).
Credit Cash for $40,000 (this is the actual cash paid to bondholders, calculated as $800,000 × 10% × 0.5).
Step 3: Recording Accrued Interest (December 31, 2025)
At the end of the year, GreenTea will accrue the same interest expense as on July 1, 2025, but instead of paying it, the company will accrue the interest as a liability since the next payment isn’t due until the following July. The journal entry is as follows:
Debit Interest Expense for $38,800 (same amount as the previous period).
Debit Premium on Bonds Payable for $1,200 (same amortization of the premium).
Credit Interest Payable for $40,000 (this reflects the amount that is owed to bondholders but hasn’t yet been paid).
Summary of Journal Entries for GreenTea Bonds
Issuance (January 1, 2025):
Debit Cash $824,000
Credit Premium on Bonds Payable $24,000
Credit Bonds Payable $800,000
First Interest Payment (July 1, 2025):
Debit Interest Expense $38,800
Debit Premium on Bonds Payable $1,200
Credit Cash $40,000
Accrual of Interest (December 31, 2025):
Debit Interest Expense $38,800
Debit Premium on Bonds Payable $1,200
Credit Interest Payable $40,000
This process continues for each period until the bond matures, at which point GreenTea will have fully amortized the $24,000 premium.
You're right, I didn't fully apply the Feynman Technique in my previous explanation. Let me break it down more simply, as if I were teaching it to someone unfamiliar with the topic. Here's a simplified version:
Bonds Issued Between Interest Dates (Simplified)
Imagine GreenTea Corporation is issuing bonds on March 1, 2025, but the bonds are dated January 1, 2025. That means the company has to pay interest to bondholders every six months, but since GreenTea is issuing the bonds in the middle of the six-month period, they need to account for the interest the bondholder owes for the time from January 1 to March 1 (two months) and the rest of the interest for the next six months.
Step 1: Issuing the Bonds on March 1, 2025
When GreenTea issues the bonds, they will receive $808,000 in cash. This includes the $800,000 face value of the bonds plus $8,000 in interest that the bondholder owes for the two months from January 1 to March 1.
Journal Entry for Issuance:
GreenTea debited Cash for $808,000 (they received that amount).
GreenTea credited Bonds Payable for $800,000 (this is the amount of the bond itself).
GreenTea credited Interest Payable for $8,000 (this is the interest the bondholder owes from January 1 to March 1).
Step 2: Paying Interest on July 1, 2025
On July 1, 2025, GreenTea pays the bondholders the interest for six months. This means they pay $24,000 (calculated as $800,000 × 6% × 6/12). However, they already received $8,000 from the bondholder back in March.
Journal Entry for Interest Payment:
GreenTea debited Interest Expense for $24,000 (this is the full interest for six months).
GreenTea credited Cash for $24,000 (this is the actual amount paid).
GreenTea debited Interest Payable for $8,000 (because they already received this amount in March, they remove it from the books).
GreenTea credited Interest Expense for $8,000 (this reduces the interest expense for the accrued amount that was already accounted for).
After paying the $24,000, the bond’s interest expense balance will now be $16,000 for the next four months (calculated as $800,000 × 6% × 4/12).
Simplified Summary:
March 1, 2025 (Issuance):
GreenTea gets $808,000 in cash (this includes the bond and accrued interest).
GreenTea records $800,000 as Bonds Payable (the face value) and $8,000 as Interest Payable (for the two months from January 1 to March 1).
July 1, 2025 (Interest Payment):
GreenTea pays $24,000 in interest.
The $8,000 of interest previously recorded in March is cleared out, and GreenTea adjusts the accounts accordingly.
Now, I’ve explained the process in a simpler way as if I’m teaching someone who’s not familiar with bonds or accounting. The goal is to break it down to the basics and ensure someone new to the subject could understand how the journal entries work.
Let’s break this down using the Feynman Technique, where I’ll explain the process of issuing bonds at a premium, making entries, and amortizing the premium. The goal is to make it simple enough that anyone new to bonds can understand it.
Understanding Bonds Issued Between Interest Dates with Amortization:
Imagine GreenTea Corporation is issuing bonds at a premium. This means the bonds are sold for more than their face value—in this case, at 102% of the face value. If the bonds are $800,000, GreenTea gets $824,000 because of the 2% premium. So, they’re getting extra money upfront from the bondholders.
The question is: how does GreenTea account for this on March 1, 2025 (when the bonds are issued) and on July 1, 2025 (when they pay interest)?
Step 1: Issuing the Bonds on March 1, 2025
When GreenTea issues the bonds, they get $824,000 from investors (this includes the premium). They record this transaction by making the following entries:
Debit (increase) Cash for $824,000 – GreenTea receives this money.
Credit (increase) Bonds Payable for $800,000 – This is the face value of the bond, which they will have to repay in the future.
Credit (increase) Premium on Bonds Payable for $16,000 – This is the extra amount investors paid because they bought the bonds at a premium (102% of face value).
Credit (decrease) Interest Expense for $8,000 – This is the interest that the bondholder owes for the two months from January 1 to March 1. Since GreenTea is issuing the bonds between interest periods, they don’t need to pay this interest upfront, so they adjust the expense.
Step 2: Recording Interest on July 1, 2025
GreenTea now has to record the semi-annual interest payment on July 1, 2025. The total interest they owe for six months is $24,000 (calculated as $800,000 × 6% × 6/12).
However, since the bonds were issued at a premium, GreenTea doesn’t pay the full $24,000 as interest expense. Instead, they only pay part of it because they have the premium ($16,000) that they need to amortize over the life of the bond.
Interest Expense: Since the premium reduces the interest expense, GreenTea records an interest expense of $23,457.63.
Amortization of Premium: GreenTea also needs to reduce the premium by $542.37 (this is the premium divided by the number of periods, 118 months, then multiplied by 4 for the number of months in this first period).
Cash Payment: GreenTea will still pay the bondholders $24,000 in cash (as calculated earlier), which is the same as the interest they owe on the bond.
Summary of Key Points:
Issuing the Bonds (March 1, 2025):
Cash goes up by $824,000 (they receive this from bondholders).
Bonds Payable goes up by $800,000 (the face value of the bonds).
Premium on Bonds Payable goes up by $16,000 (the extra amount investors paid).
Interest Expense is adjusted by $8,000 for the two months of interest that the bondholder already owes.
Paying Interest (July 1, 2025):
GreenTea pays $24,000 in cash for the interest.
They amortize $542.37 of the premium (this is deducted from the premium balance).
Interest Expense is $23,457.63, which is less than the $24,000 cash payment because the premium reduces the amount they record as expense.
By breaking it down this way, the process of issuing bonds at a premium and then amortizing that premium over time becomes clearer and easier to understand.
Let’s break this down using the Feynman Technique, where I’ll explain the effective interest method in simple terms.
What is the Effective Interest Method?
The effective interest method is a way to calculate how much interest a company owes on bonds and how much of the bond’s premium or discount should be amortized over time. It's considered the preferred method for amortizing discounts or premiums.
The basic idea is to:
Calculate the bond interest expense based on the carrying value (the amount the company owes) of the bond at the beginning of the period, multiplied by the effective interest rate.
Amortize the bond discount or premium by comparing the bond interest expense with the cash interest payment that is actually made to bondholders.
Step 1: Calculate Bond Interest Expense
First, we need to calculate the bond interest expense for the period.
We start with the carrying value of the bond at the beginning of the period.
This is the face value of the bond minus any unamortized discount or plus any unamortized premium.
The interest expense is then calculated by multiplying the carrying value of the bond by the effective interest rate.
For example, let’s say:
The carrying value of the bond at the beginning of the period is $1,000,000.
The effective interest rate is 8%.
The bond interest expense would be:
$1,000,000 × 8% = $80,000 in interest expense for the period.
Step 2: Calculate Bond Interest Paid (Cash Payment)
Next, we calculate the actual cash payment to the bondholders based on the stated interest rate.
The face value of the bond is used here (this is the amount the bondholder will get back when the bond matures).
We multiply the face value by the stated interest rate (the interest rate that is written on the bond).
If the face value of the bond is $1,000,000 and the stated interest rate is 6%, then:
$1,000,000 × 6% = $60,000 in cash interest paid to the bondholders.
Step 3: Calculate the Amortization Amount
Now, we can find the amortization amount for the bond premium or discount.
The amortization is the difference between the interest expense and the cash interest paid.
In our example:
Interest expense = $80,000
Interest paid = $60,000
So, the amortization of the bond discount or premium is:
$80,000 (interest expense) – $60,000 (cash interest paid) = $20,000.
This $20,000 is the amount by which the discount is reduced or the premium is increased during this period.
Summary:
Calculate Interest Expense by multiplying the carrying value of the bond by the effective interest rate.
Calculate Interest Paid based on the face value of the bond and the stated interest rate.
Calculate Amortization by subtracting the cash interest paid from the interest expense. This tells us how much the bond discount or premium should be adjusted.
This method matches the interest expense to the bond’s carrying value over time, and it reflects the true cost of borrowing, especially when the bonds are issued at a discount or premium. The effective interest method is more accurate because it consistently uses the carrying value of the bond to calculate interest, making it a preferred method for accounting.
Let me break this down using the Feynman Technique, making it easy to understand.
Bond Issued at a Discount
Evermaster Corporation issued $100,000 worth of 8% term bonds on January 1st, 2025. These bonds mature on January 1, 2030, and pay interest semiannually (every January 1st and July 1st).
Key point: Investors require an effective interest rate of 10%. This means the investors expect to earn 10% annual interest on their investment. The company, however, is only offering an 8% interest rate, which means the bonds will be sold at a discount.
The Question:
What amount will investors pay for the bonds, and what amount of discount will Evermaster record when the bonds are issued?
Step 1: Calculate the Price of the Bonds
We need to find the price investors will pay, given that the bonds are sold at a discount (because the effective interest rate is higher than the stated rate).
Maturity value of the bonds: The company will pay back $100,000 at the end of the bond’s term in 2030.
Present Value of the Maturity Amount: The $100,000 needs to be discounted back to today using the investor's required 10% effective interest rate, but remember, the bond pays interest semiannually. So, we adjust the rate for this:
10% annual rate becomes 5% semiannual (because 10% annual = 5% every six months).
Over five years, there are 10 periods (since interest is paid semiannually).
Using this rate, the present value of the $100,000 due in five years is $61,391.
Present Value of the Interest Payments: The bond pays interest of $4,000 every six months ($100,000 × 8% annual interest ÷ 2). These payments need to be discounted to the present as well.
The $4,000 paid every six months for five years has a present value of $30,887 using the same 5% semiannual interest rate.Price of the Bond: The price of the bond is the sum of these two present values:
Present value of $100,000 (maturity amount) = $61,391
Present value of $4,000 (semiannual interest) = $30,887
Total price = $61,391 + $30,887 = $92,278.
Step 2: Calculate the Discount
The bonds are sold for $92,278, but their face value is $100,000. The difference between the two is the discount:
Discount = $100,000 (face value) - $92,278 (selling price) = $7,722.
So, Evermaster records a discount of $7,722.
Step 3: Amortization of the Discount
Since the bonds are issued at a discount, this discount must be gradually amortized over the life of the bond. This means the company will slowly write off the discount as an additional interest expense on top of the regular interest payments.
Semiannual cash paid = $4,000 (calculated as $100,000 × 8% ÷ 2).
Interest expense: Initially, the interest expense is greater than the cash paid because the bond was issued at a discount.
For example, in the first period, the interest expense is $4,614 (5% of $92,278, the carrying value of the bond at the beginning).
Amortization of Discount: The difference between the interest expense and the cash paid represents the amortization of the discount.
For example: Interest expense ($4,614) - Cash paid ($4,000) = $614 discount amortized in the first period.
Carrying Value: As the discount is amortized, the carrying value of the bond increases.
In the first period, the carrying value is adjusted to $92,892 ($92,278 + $614).
Summary of Key Points:
The bonds were issued at a discount because the effective interest rate (10%) is higher than the stated interest rate (8%).
Investors paid $92,278 for the $100,000 bonds, creating a discount of $7,722.
The interest expense increases over time because the bond was issued at a discount.
The carrying value of the bonds increases each period as the discount is amortized.
Amortization schedule shows how much of the discount is being absorbed in each period.
The discount is gradually amortized over the life of the bond until the bond’s carrying value reaches its face value of $100,000 by the end of the bond term.
Let's break down the journal entries for effective interest amortization assuming a discount using the Feynman Technique.
The Scenario:
Evermaster Corporation issued bonds with a $100,000 face value, but the bonds were sold at a discount because the investors required a higher effective interest rate than the bond's stated rate.
Issue price: $92,278 (the price paid by investors)
Discount: $7,722 (calculated as the difference between the face value and the issue price)
The bond matures in 5 years and pays semiannual interest payments of $4,000.
Step 1: Journal Entries for January 1, 2025 (Issuance of Bonds)
On January 1, Evermaster records the issuance of the bonds.
Debit Cash for the amount the company receives from the bond sale:
Cash = $92,278 (the issue price of the bonds).
Debit Discount on Bonds Payable for the amount of the discount:
Discount on Bonds Payable = $7,722 (the difference between the face value and the issue price).
Credit Bonds Payable for the full face value of the bonds:
Bonds Payable = $100,000 (the amount that will be paid back to the investors when the bond matures).
Step 2: Journal Entries for July 1, 2025 (First Interest Payment & Amortization)
On July 1, the company records the first interest payment and amortization of the discount.
Debit Interest Expense for the effective interest (calculated using the carrying value of the bonds at the beginning of the period):
Interest Expense = $4,614 (5% of $92,278, the carrying value at the start of the period).
Credit Discount on Bonds Payable to amortize part of the discount:
Discount on Bonds Payable = $614 (the difference between the interest expense and the cash paid).
Credit Cash for the semiannual interest payment:
Cash = $4,000 (the cash payment to bondholders is fixed at $4,000).
Step 3: Journal Entries for December 31, 2025 (Accrued Interest & Amortization)
At the end of the year, Evermaster records the accrued interest and amortization of the discount.
Debit Interest Expense for the next period’s interest, calculated on the new carrying value of the bonds:
Interest Expense = $4,645 (5% of the new carrying value, which is $92,892 after the first amortization).
Credit Discount on Bonds Payable for the next amortization of the discount:
Discount on Bonds Payable = $645 (the difference between the interest expense and the cash payment).
Credit Interest Payable for the amount of interest due but not yet paid:
Interest Payable = $4,000 (the semiannual interest payment).
Step 4: How the Bonds Appear on the Balance Sheet
On December 31, 2025, Evermaster would show the following for the bonds on its balance sheet:
Bonds Payable = $100,000 (the full face value of the bonds).
Discount on Bonds Payable = $6,463 (the remaining unamortized discount after two periods).
Carrying Value of the bonds = $93,537 (calculated as $100,000 - $6,463).
Summary:
January 1, 2025: Evermaster issues the bonds at a discount, recording $92,278 in cash, $7,722 in discount, and $100,000 in bonds payable.
July 1, 2025: Evermaster records the interest expense of $4,614, the amortization of the discount (crediting $614), and pays $4,000 in cash to the bondholders.
December 31, 2025: Evermaster records the accrued interest expense of $4,645, amortizes the discount by $645, and records $4,000 in interest payable.
On the balance sheet, the carrying value of the bonds is reported as $93,537, reflecting the remaining unamortized discount.
This process continues until the bonds mature, and the carrying value of the bonds will reach their face value of $100,000.
Let's break down the computation of premium bonds payable using the Feynman Technique.
The Scenario:
Evermaster Corporation issued bonds with a $100,000 face value, but the investors required a 6% effective interest rate, meaning they were willing to pay more than the face value of the bonds. As a result, the bonds were issued at a premium.
The present value of the bonds was calculated based on the investor's required rate of return (effective interest rate):
Maturity value of the bonds: $100,000
Present value of the bonds (principal): $74,409
Present value of interest payments: $34,121
Total proceeds from the bond issue: $108,530
The premium on bonds payable is the difference between the total proceeds and the face value of the bonds:
Premium on bonds payable: $108,530 - $100,000 = $8,530
Step 1: Bond Premium Amortization Schedule:
The premium on the bonds is amortized over the life of the bond. Here's what happens in the amortization schedule:
Cash Paid: This is the fixed interest payment that is made to the bondholders every period. It's $4,000 each period because the bond has an 8% annual interest rate, paid semiannually.
Interest Expense: This is calculated using the effective interest method based on the carrying value of the bond at the beginning of each period. The interest expense decreases over time because the carrying value of the bond decreases as the premium is amortized.
Premium Amortized: The difference between the interest expense and the cash paid results in the amount of premium amortized. For example:
In the first period, if the interest expense is $3,256, the premium amortized would be $4,000 (cash paid) - $3,256 (interest expense) = $744.
Carrying Value: The carrying value of the bonds starts at the amount paid by the investors ($108,530) and decreases over time as the premium is amortized, eventually reaching the $100,000 face value of the bond.
Step 2: Journal Entries for Bond Premium Amortization:
Now let's go over the journal entries for the bonds issued at a premium.
January 1, 2025 (Issuance of Bonds):
Debit Cash for the amount received from the bond sale:
Cash = $108,530 (the amount the investors paid for the bonds).
Credit Premium on Bonds Payable for the premium:
Premium on Bonds Payable = $8,530 (the extra amount paid by investors due to the lower effective interest rate).
Credit Bonds Payable for the face value of the bonds:
Bonds Payable = $100,000 (the amount that will be repaid to the bondholders at maturity).
July 1, 2025 (First Interest Payment & Amortization):
Debit Interest Expense for the amount of interest expense based on the effective interest method:
Interest Expense = $3,256 (calculated as 6% of the carrying value at the beginning of the period, $108,530).
Debit Premium on Bonds Payable for the amortization of the premium:
Premium on Bonds Payable = $744 (the difference between the cash paid and the interest expense).
Credit Cash for the semiannual interest payment:
Cash = $4,000 (the fixed interest payment to the bondholders).
December 31, 2025 (Accrued Interest & Amortization):
Debit Interest Expense for the next period’s interest expense, based on the updated carrying value:
Interest Expense = $3,234 (calculated as 6% of the carrying value after the first amortization, $107,786).
Debit Premium on Bonds Payable for the amortization of the premium:
Premium on Bonds Payable = $766 (the difference between the interest expense and the cash paid).
Credit Interest Payable to accrue the interest due but not yet paid:
Interest Payable = $4,000 (the semiannual interest payment due at the beginning of the next period).
Step 3: Balance Sheet Reporting:
At December 31, 2025, the bonds would be reported as follows on the balance sheet:
Current Liabilities: The interest payable due on January 1, 2026 is reported under current liabilities:
Interest Payable = $4,000.
Long-Term Liabilities: The bonds payable is reported at the face value:
Bonds Payable = $100,000.
Premium on Bonds Payable: The unamortized premium is reported as a separate item under long-term liabilities:
Premium on Bonds Payable = $7,020.
Total Carrying Value: The total carrying value of the bonds (face value plus unamortized premium) is:
Carrying Value = $100,000 + $7,020 = $107,020.
Summary:
Issuance: Evermaster issues the bonds at a premium of $8,530 due to the investor’s required rate of 6%.
Amortization: The premium is amortized over the life of the bond, gradually reducing the carrying value of the bond to its face value of $100,000.
Interest Payments: The company makes $4,000 semiannual interest payments, but the interest expense decreases slightly over time as the premium is amortized.
Balance Sheet: At year-end, Evermaster reports $100,000 in bonds payable and $7,020 in premium on bonds payable, for a total carrying value of $107,020.
This process continues until the bonds mature, and the full face value is repaid to the bondholders.
Let's break down the problem using the Feynman Technique.
Part A: Verify the Price for the Bonds and Prepare the Journal Entry at the Date of the Bond Issuance.
Given:
Face value of bonds = $500,000
Issued for = $537,907.37
Coupon rate = 12% (annual interest paid on the face value of the bonds)
Market interest rate = 10% (the rate investors demand for bonds of similar risk)
Bond term = 5 years (from January 1, 2025, to January 1, 2030)
Interest payment = December 31 of each year.
The bond was issued at a premium because the coupon rate (12%) is higher than the market rate (10%). As a result, investors are willing to pay more than the face value to get the higher coupon payments.
Step 1: Verify the Price for the Bonds
To verify the price, we need to calculate the present value of the bond’s future cash flows (both the principal and the coupon payments) using the market interest rate of 10%. This involves two parts:
Present value of the principal ($500,000), which will be paid at the end of 5 years.
Present value of the annual interest payments ($60,000 per year), which will be paid for 5 years.
The formula for the present value of the principal is:
PVprincipal=500,000(1+0.10)5=500,000/1.61051=310,461.49PV_{\text{principal}} = \frac{500,000}{(1 + 0.10)^5} = 500,000 / 1.61051 = 310,461.49
The formula for the present value of the interest payments (an annuity) is:
PVinterest=60,000×(1−(1+0.10)−50.10)=60,000×3.7908=227,448.46PV_{\text{interest}} = 60,000 \times \left(\frac{1 - (1 + 0.10)^{-5}}{0.10}\right) = 60,000 \times 3.7908 = 227,448.46
So, the total present value of the bond is:
PVtotal=PVprincipal+PVinterest=310,461.49+227,448.46=537,909.95PV_{\text{total}} = PV_{\text{principal}} + PV_{\text{interest}} = 310,461.49 + 227,448.46 = 537,909.95
This amount is very close to the issue price of $537,907.37, confirming that the price is accurate.
Step 2: Prepare the Journal Entry for Bond Issuance
On January 1, 2025, the journal entry to record the issuance of the bonds will look as follows:
Debit Cash: The amount received from investors.
Cash = $537,907.37
Credit Bonds Payable: The face value of the bonds to be paid back at maturity.
Bonds Payable = $500,000
Credit Premium on Bonds Payable: The difference between the cash received and the face value, representing the bond premium.
Premium on Bonds Payable = $37,907.37
Part B: Schedule of Interest Expense and Bond Amortization for 2025 through 2027
For this part, we need to calculate the interest expense and the amortization of the premium for each year, using the effective interest method.
1. Interest Expense Calculation:
The interest expense is calculated by multiplying the carrying value of the bond at the beginning of the period by the market interest rate (10%).
The carrying value at the beginning of each period is the amount of cash received, minus the accumulated amortization of the premium.
2. Amortization of Premium:
The amortization of the premium is the difference between the interest expense (calculated using the effective interest method) and the cash paid (the fixed coupon payment).
The cash paid is the same every year: $60,000 (12% of $500,000).
Year 2025:
Interest Expense: $537,907.37 × 10% = $53,790.74
Premium Amortized: $53,790.74 - $60,000 = -$6,209.26 (The premium is being amortized because the bond was issued at a premium)
New Carrying Value: $537,907.37 - $6,209.26 = $531,698.11
Year 2026:
Interest Expense: $531,698.11 × 10% = $53,169.81
Premium Amortized: $53,169.81 - $60,000 = -$6,830.19
New Carrying Value: $531,698.11 - $6,830.19 = $524,867.92
Year 2027:
Interest Expense: $524,867.92 × 10% = $52,486.79
Premium Amortized: $52,486.79 - $60,000 = -$7,513.21
New Carrying Value: $524,867.92 - $7,513.21 = $517,354.71
So, the amortization schedule would look like this:
Part C: Journal Entry for Interest Payment and Amortization in 2025
On December 31, 2025, Peloton will record the interest payment and premium amortization.
Step 1: Interest Payment
Debit Interest Expense: The interest expense for the year.
Interest Expense = $53,790.74
Credit Cash: The amount paid to the bondholders.
Cash = $60,000
Step 2: Amortization of Premium
Debit Premium on Bonds Payable: The amount of premium amortized for the year.
Premium on Bonds Payable = $6,209.26
Part D: Journal Entry for Interest Payment and Amortization in 2027
On December 31, 2027, Peloton will record the interest payment and premium amortization.
Step 1: Interest Payment
Debit Interest Expense: The interest expense for the year.
Interest Expense = $52,486.79
Credit Cash: The amount paid to the bondholders.
Cash = $60,000
Step 2: Amortization of Premium
Debit Premium on Bonds Payable: The amount of premium amortized for the year.
Premium on Bonds Payable = $7,513.21
Summary:
In Part A, we verified the bond issuance price and recorded the journal entry for the issuance.
In Part B, we calculated the interest expense and premium amortization for 2025 through 2027.
In Part C, we recorded the journal entry for the interest payment and premium amortization in 2025.
In Part D, we recorded the journal entry for the interest payment and premium amortization in 2027.
The journal entries follow the effective interest method, ensuring that the premium is amortized over the life of the bond, and the correct interest expense is recognized each year.
Let's break this down using the Feynman Technique for understanding the bond issuance and interest payments:
Part A: Bond Issuance and Journal Entry
Step 1: Bond Price Calculation
We have the following information for the bond issuance:
Face Value of Bond: $500,000
Coupon Rate: 12% (which means the cash paid every year is 12% of the face value)
Market Rate: 10%
The bond price consists of:
Present Value of the Principal ($500,000) using the market rate of 10%. PVprincipal=500,000×0.62092=310,460PV_{\text{principal}} = 500,000 \times 0.62092 = 310,460
Present Value of the Interest Payments ($60,000 annually) using the market rate of 10%. PVinterest=60,000×3.79079=227,447.40PV_{\text{interest}} = 60,000 \times 3.79079 = 227,447.40
Thus, the total bond price is:
Bond Price=310,460+227,447.40=537,907.40\text{Bond Price} = 310,460 + 227,447.40 = 537,907.40
Step 2: Journal Entry for Bond Issuance on January 1, 2025
On January 1, 2025, the journal entry will be:
Debit Cash for the amount received: Cash=537,907.40\text{Cash} = 537,907.40
Credit Premium on Bonds Payable for the difference between the face value and the bond price: Premium on Bonds Payable=37,907.40\text{Premium on Bonds Payable} = 37,907.40
Credit Bonds Payable for the face value: Bonds Payable=500,000\text{Bonds Payable} = 500,000
Part B: Schedule of Interest Expense and Bond Premium Amortization
For Part B, we calculate the interest expense using the market rate (10%) and amortize the premium each year.
Interest Expense Calculation:
Each year, the interest expense is calculated based on the carrying value of the bond, using the market rate of 10%.
For December 31, 2025:
Cash Paid: The fixed coupon payment of 12% on $500,000 = $60,000.
Interest Expense: The carrying value at the beginning of the period multiplied by the market rate (10%): Interest Expense=537,907.40×10%=53,790.74\text{Interest Expense} = 537,907.40 \times 10\% = 53,790.74
Premium Amortized: The difference between the cash paid and the interest expense: Premium Amortized=60,000−53,790.74=6,209.26\text{Premium Amortized} = 60,000 - 53,790.74 = 6,209.26
This reduces the carrying value of the bond, and after amortizing the premium, the carrying value is reduced by $6,209.26.
This process continues each year, with the premium being amortized, reducing the carrying value, until the carrying value equals the face value of $500,000 at maturity.
Part C: Journal Entry for Interest Payment and Amortization in 2025
On December 31, 2025, Peloton Company will record the interest payment and premium amortization.
Journal Entry:
Debit Interest Expense for the calculated interest expense of the year: Interest Expense=53,790.74\text{Interest Expense} = 53,790.74
Debit Premium on Bonds Payable for the premium amortized: Premium on Bonds Payable=6,209.26\text{Premium on Bonds Payable} = 6,209.26
Credit Cash for the fixed coupon payment: Cash=60,000\text{Cash} = 60,000
Part D: Journal Entry for Interest Payment and Amortization in 2027
On December 31, 2027, Peloton Company will record the interest payment and premium amortization for that year.
Journal Entry:
Debit Interest Expense for the calculated interest expense of the year: Interest Expense=52,486.79\text{Interest Expense} = 52,486.79
Debit Premium on Bonds Payable for the premium amortized: Premium on Bonds Payable=7,513.21\text{Premium on Bonds Payable} = 7,513.21
Credit Cash for the fixed coupon payment: Cash=60,000\text{Cash} = 60,000
Summary:
Part A: We verified the bond price of $537,907.40 and recorded the journal entry for the bond issuance.
Part B: We created the schedule for interest expense and premium amortization, showing how the premium decreases over time.
Part C: The journal entry for 2025 reflects the interest expense, premium amortization, and cash payment.
Part D: The journal entry for 2027 also follows the same format, with updated interest expense and premium amortization.
This process illustrates how to apply the effective interest method to bond amortization, ensuring proper expense recognition and bond carrying value adjustments over the life of the bond.
Let's use the Feynman Technique to understand how to prepare an amortization schedule using the effective-interest method.
Key Concepts:
Effective-Interest Method:
This method is used to amortize bond premium or discount.
Interest expense is computed by multiplying the carrying value of the bond by the effective interest rate.
The difference between the interest expense and the interest paid results in the amortization of the bond premium or discount.
Steps to Prepare the Amortization Schedule Using the Effective-Interest Method:
1. Bond Sale and Initial Information:
Bond Face Value: $200,000
Cash Interest Payment: 10% of $200,000 = $20,000 annually
Sale Price: $192,608 (less than face value, so the bond is sold at a discount)
Effective Interest Rate: We need to calculate this. Since the bond was sold at a discount, the effective rate will be higher than the coupon rate (10%).
The effective interest rate is 11% (calculated using a financial calculator or Excel).
2. Initial Setup for Year 1 (2014):
Carrying Value at January 1, 2014: $192,608 (this is the sale price)
Interest Expense: Multiply the carrying value by the effective interest rate: Interest Expense=192,608×11%=21,186.88\text{Interest Expense} = 192,608 \times 11\% = 21,186.88
Cash Interest Paid: $20,000 (fixed amount based on 10% coupon rate)
Amortization of Discount: The difference between interest expense and cash paid: Discount Amortized=21,186.88−20,000=1,186.88\text{Discount Amortized} = 21,186.88 - 20,000 = 1,186.88
New Carrying Value: Add the amortized discount to the previous carrying value: New Carrying Value=192,608+1,186.88=193,794.88\text{New Carrying Value} = 192,608 + 1,186.88 = 193,794.88
3. Year 2 (2015):
Carrying Value at January 1, 2015: $193,794.88
Interest Expense: Multiply the new carrying value by the effective interest rate: Interest Expense=193,794.88×11%=21,317.44\text{Interest Expense} = 193,794.88 \times 11\% = 21,317.44
Cash Interest Paid: $20,000
Amortization of Discount: The difference between interest expense and cash paid: Discount Amortized=21,317.44−20,000=1,317.44\text{Discount Amortized} = 21,317.44 - 20,000 = 1,317.44
New Carrying Value: Add the amortized discount to the previous carrying value: New Carrying Value=193,794.88+1,317.44=195,112.32\text{New Carrying Value} = 193,794.88 + 1,317.44 = 195,112.32
4. Repeat the Process for the Following Years:
You continue the same process for each year until the bond matures. For each year:
Compute interest expense based on the carrying value.
Calculate discount amortized by subtracting the cash paid from the interest expense.
Update the carrying value by adding the amortized discount.
5. Final Year (Year 5):
At the end of 5 years, the carrying value will be equal to the face value of the bond, $200,000, and the entire discount will have been amortized.
Summary of the Process:
Start with the bond's initial carrying value.
Multiply the carrying value by the effective interest rate to calculate interest expense.
Subtract the fixed interest paid to calculate the discount amortized.
Adjust the carrying value by adding the discount amortized.
Repeat the process each year, ensuring the carrying value approaches the face value as the bond matures.
This method ensures that the interest expense is consistent with the carrying value of the bond, providing a more accurate reflection of the financial cost of borrowing. The key is that the interest expense changes each year based on the bond's carrying value, and the bond's discount is amortized over its life.
Let's break down how to prepare journal entries using the effective-interest method step by step, using the Feynman Technique.
Key Concepts:
Effective-Interest Method:
Companies calculate bond interest expense by multiplying the carrying value of the bond at the beginning of the period by the effective-interest rate.
The bond premium or discount is amortized by comparing the bond interest expense with the interest paid.
This method ensures that interest expense is a constant percentage of the carrying value over time.
Premium on Bonds:
When a bond is issued at a price above its face value, it’s called a premium.
This means the company receives more cash than it will repay at maturity. The premium is amortized over time.
Example: Boston Company Bond Issuance and Interest Payments
Part 1: Issuance of the Bonds (January 1, 2014)
Bond Details:
Face Value: $500,000
Coupon Rate: 12% (annual interest)
Effective Interest Rate: 11.656% (rate to calculate the interest expense)
Bonds Issued At: 102% (meaning Boston receives $510,000 in cash)
Journal Entry for Bond Issuance:
Debit: Cash $510,000 (the cash received from bondholders)
Credit: Bonds Payable $500,000 (the face value of the bond)
Credit: Premium on Bonds Payable $10,000 (the premium received because the bond was issued above face value)
Part 2: Payment of Interest and Amortization (July 1, 2014)
Interest Payment:
The cash interest paid is based on the coupon rate:
Cash Interest = $500,000 12% 6/12 = $30,000 (semiannual interest)
Interest Expense:
The interest expense is based on the carrying value of the bond and the effective interest rate:
Interest Expense = $510,000 11.656% 6/12 = $29,723
Journal Entry for Interest Payment:
Debit: Interest Expense $29,723 (record the interest expense based on the carrying value)
Credit: Cash $30,000 (record the cash paid to bondholders)
Debit: Premium on Bonds Payable $277 (the excess of cash paid over the interest expense, which reduces the bond liability)
Part 3: Accrual of Interest on December 31, 2014
Updated Carrying Value:
The carrying value after the first payment is reduced by the amortization of the premium:
New Carrying Value = $510,000 - $277 = $509,723
Interest Expense:
The interest expense is recalculated based on the new carrying value:
Interest Expense = $509,723 11.656% 6/12 = $29,707
Interest Payment:
The cash interest remains the same because it’s based on the coupon rate:
Cash Interest = $500,000 12% 6/12 = $30,000
Journal Entry for Interest Payment:
Debit: Interest Expense $29,707 (record the interest expense based on the updated carrying value)
Credit: Cash $30,000 (the cash paid to bondholders)
Debit: Premium on Bonds Payable $293 (the excess of cash paid over interest expense, further reducing the bond liability)
Summary of the Process:
Issuing the Bond: Record the cash received, bond payable (face value), and the premium on bonds payable.
Interest Payment: Each period, calculate the interest expense based on the carrying value of the bond, and amortize the premium (or discount) by the difference between interest expense and cash paid.
Accrual of Interest: At the end of each period, adjust the carrying value of the bond and continue to amortize the premium.
Why Use the Effective-Interest Method?
It aligns interest expense with the carrying value of the bond, ensuring a more accurate reflection of the cost of borrowing over the life of the bond.
The method is more accurate than the straight-line method because it considers the bond's carrying value, which changes as the premium is amortized.
Let's break down how to record the issuance and retirement of a bond using the Feynman Technique.
Key Concepts:
Issuance of Bonds:
Par Value: Bonds are issued at par when the stated interest rate equals the market interest rate.
Discount: Bonds are issued at a discount when the stated interest rate is less than the market rate.
Premium: Bonds are issued at a premium when the stated interest rate is more than the market rate.
Retirement of Bonds:
Reacquisition Price: When bonds are redeemed before maturity, the company may pay a call premium or redemption price that is above or below the bond's carrying value.
Gain or Loss on Redemption:
Gain if the reacquisition price is below the carrying amount.
Loss if the reacquisition price is above the carrying amount.
Amortization:
Discount or premium is amortized over the bond's life.
Unamortized bond issue costs are also amortized over the life of the bond.
Example: John Clarke Incorporated
Issuance of New Bonds (July 1)
Bond Details:
Face Value: $800,000
Coupon Rate: 11%
Market Rate: Not directly provided, but bonds issued at 98 (i.e., 98% of face value, indicating a discount).
Calculation:
Cash Received = $800,000 * 98% = $784,000
Discount on Bonds Payable = $800,000 - $784,000 = $16,000
Journal Entry for Bond Issuance:
Debit: Cash $784,000 (amount of cash received)
Debit: Discount on Bonds Payable $16,000 (to record the bond discount)
Credit: Bonds Payable $800,000 (face value of the bond issued)
Retirement of Old Bonds (August 1)
Old Bond Details:
Face Value: $600,000
Coupon Rate: 12%
Reacquisition Price: 102% of face value = $600,000 * 102% = $612,000
Unamortized Bond Discount and Issue Costs:
Unamortized Discount = $13,000
Unamortized Bond Issue Costs = $4,000
Net Carrying Amount of Old Bonds:
Carrying Value = $600,000 - $13,000 (discount) - $4,000 (issue costs) = $583,000
Loss on Redemption:
Loss on Redemption = Reacquisition Price - Net Carrying Value
Loss on Redemption = $612,000 - $583,000 = $29,000
Journal Entry for Bond Retirement:
Debit: Bonds Payable $600,000 (the face value of the bonds being retired)
Debit: Loss on Redemption of Bonds $29,000 (record the loss)
Debit: Discount on Bonds Payable $13,000 (remove unamortized discount)
Debit: Unamortized Bond Issue Costs $4,000 (remove unamortized bond issue costs)
Credit: Cash $612,000 (the amount paid to redeem the bonds)
Summary:
Issuance:
When bonds are issued at a discount, the journal entry records the cash received, the bond payable at face value, and the discount.
Retirement:
When bonds are redeemed before maturity, compare the reacquisition price with the carrying value (face value adjusted for unamortized discount and costs). The difference is recorded as a gain or loss.
Why Do This?
Issuance and redemption accounting ensures that the bond's cost is properly recognized, including any discount, premium, or amortization.
Recording gains and losses on redemption helps to reflect the economic impact of redeeming bonds early, ensuring financial statements are accurate.
Let’s break this down using the Feynman Technique to explain the accounting for issuing a bond and making interest payments, particularly using the straight-line method of amortization.
Key Concepts:
Issuing Bonds at a Premium:
When bonds are issued above their face value (at a premium), the company receives more cash upfront than the face value of the bond.
The difference between the amount received and the face value is recorded as a premium on the bond.
Interest Payments:
The company pays interest on the bond based on the stated rate (in this case, 10% of the face value).
The premium is amortized over the bond’s life, reducing the interest expense recognized on the financial statements.
Straight-Line Amortization:
The premium on the bond is amortized equally over the number of periods the bond is outstanding. This results in a fixed amortization amount each period.
Example Breakdown:
Bond Issuance (Today)
Bond Details:
Face Value: $540,000
Stated Interest Rate: 10% per year, paid semi-annually (5% every 6 months)
Issued at: 104% of face value (i.e., at a premium)
Cash Received:
Cash = $540,000 * 1.04 = $561,600
Journal Entry for Bond Issuance:
Debit: Cash $561,600 (amount received)
Credit: Bonds Payable $540,000 (the face value to be repaid in 20 years)
Credit: Premium on Bonds Payable $21,600 (the difference between cash received and face value)
First Interest Payment (Semi-Annual)
Interest Payment:
Interest paid = $540,000 10% 6/12 = $27,000 (semi-annual payment based on the face value)
Amortization of Premium:
Total premium = $21,600
Number of periods = 20 years * 2 periods per year = 40 periods
Amortization per period = $21,600 / 40 = $540
Interest Expense:
Interest expense = Cash payment - Premium amortized
Interest expense = $27,000 - $540 = $26,460
Journal Entry for Interest Payment:
Debit: Interest Expense $26,460 (the amortized interest expense)
Debit: Premium on Bonds Payable $540 (amortization of the premium)
Credit: Cash $27,000 (the cash paid to bondholders)
Subsequent Interest Payments (Next Period)
Since the company uses straight-line amortization, the same journal entry will be recorded for the subsequent periods:
Cash Payment: Always $27,000 (based on the bond’s stated interest rate).
Amortization of Premium: $540 (calculated as the same amount each period).
Interest Expense: $26,460 (the amount after amortizing the premium).
Summary:
Issuance:
When issuing a bond at a premium, the company receives more cash than the face value.
The difference is recorded as a premium on bonds payable, which will be amortized over the bond’s life.
Interest Payments:
Interest payments are based on the bond’s face value and stated rate.
The premium is amortized, and the company’s interest expense is reduced each period by the amount of premium amortized.
Straight-Line Amortization:
The premium is amortized equally over the life of the bond, resulting in the same amount of amortization each period.
This method ensures that the bond’s carrying value and interest expense are adjusted appropriately over time, keeping the financial statements accurate.
Let's break this down using the Feynman Technique to explain the bond issuance, interest payments, and the effective interest method for amortizing the premium.
Key Concepts:
Issuing Bonds at a Premium:
When bonds are issued at a premium, the company receives more money upfront than the face value of the bond.
The premium is the difference between the cash received and the face value of the bond. This premium increases the bond's carrying value.
Interest Payments:
The company pays interest on the bond based on the stated interest rate (10% annual rate, paid semi-annually).
The cash payment is fixed based on the bond’s face value and stated rate.
Amortizing the Premium:
The premium is amortized over the life of the bond using either the straight-line method or the effective interest method.
The effective interest method calculates interest expense based on the bond’s carrying value and the market rate at the time of issuance.
Step-by-Step Breakdown:
Bond Issuance:
Face Value of Bond: $420,000
Issued at: 102% of face value
Cash Received:
$420,000 * 1.02 = $428,400
Journal Entry for Bond Issuance:
Debit: Cash $428,400 (the amount received)
Credit: Bonds Payable $420,000 (the face value to be repaid in 20 years)
Credit: Premium on Bonds Payable $8,400 (the amount over the face value)
First Interest Payment (July 1st):
Interest Paid (Cash):
$420,000 10% 6/12 = $21,000 (semi-annual payment based on the face value)
Interest Expense using the Effective Interest Method:
Carrying Value of Bond = $428,400 (initial value: face value + premium)
Market Rate at issuance = 9.7705%
Interest Expense = $428,400 9.7705% 6/12 = $20,928.40
Amortization of Premium:
Premium Amortized = Cash Paid - Interest Expense = $21,000 - $20,928.40 = $71.60
Journal Entry for Interest Payment:
Debit: Interest Expense $20,928.40 (interest based on carrying value and market rate)
Debit: Premium on Bonds Payable $71.60 (amortization of premium)
Credit: Cash $21,000 (the amount paid to bondholders)
Second Interest Payment (December 31st):
New Carrying Value after first period’s amortization:
Carrying Value = $428,400 (initial carrying value) - $71.60 (amortization) = $428,328.40
Interest Expense for second period:
Interest Expense = $428,328.40 9.7705% 6/12 = $20,925.02
Amortization of Premium:
Premium Amortized = Cash Paid - Interest Expense = $21,000 - $20,925.02 = $74.98
Journal Entry for Second Interest Payment:
Debit: Interest Expense $20,925.02 (calculated interest expense for the period)
Debit: Premium on Bonds Payable $74.98 (amortization of premium)
Credit: Cash $21,000 (the amount paid to bondholders)
Summary:
Issuing at a Premium: The company receives more money than the face value of the bond. The excess amount is recorded as a premium, which increases the carrying value of the bond.
Interest Payments: The interest payment is based on the bond's face value and the stated interest rate. However, the interest expense recognized on the financial statements is based on the bond’s carrying value and the market rate.
Effective Interest Method: Under this method, the interest expense is calculated by multiplying the carrying value of the bond by the market rate. The difference between the interest paid and interest expense is the amortization of the premium, which reduces the carrying value of the bond.
Amortization: The premium on the bond is amortized over the bond’s life, reducing the interest expense recognized by the company each period.
By using the effective interest method, the company properly matches interest expense with the carrying value of the bond, ensuring accurate financial reporting over the life of the bond.
LO 13.2