2. 10-1 Amortization of Premiums: Straight-Line Method Effective-Interest Method Chapter 10 Illustrated Solution: Problem 10-35

3. 10-2 General Concerns with Bonds n A bond is like a fixed-payment contract with the interest rates and payment dates already set. n Bonds are often sold when the market rate of interest is different from the stated interest rate on the bonds. n Premium on Bonds n Discount on Bonds.

4. 10-3 Problem Background n Locust Company sells $20,000 of their bonds to Allen Company for $20,850. n Bonds pay interest of 7% (on face value), or $700 every 6 months. n Assumptions: n Market interest rate at the time bonds are sold is approximately 6%. n The $850 difference between the face value of the bonds and the purchase (sales) price of the bonds will adjust the effective interest rate back to the market rate (approximately 6%).

5. 10-4 n Every 6 months Allen Company will receive a payment from Locust Company of $700. n However, Allen Company’s interest revenue will be less than this $700 payment they receive because they paid $20,850 to acquire the bonds and they will only receive a payment of $20,000 when the bonds mature in 5 years. n Locust Company’s true interest expense is less than the $700 payment they make because they received $20,850 when they sold the bonds and they will only have to pay back $20,000 when the bonds mature in 5 years. n Question: How to account for this $850 premium? Premium on Bonds—The Concept

6. 10-5 Straight-Line Method Under the straight-line method, the total premium is amortized evenly over the life of the bonds: In this case: Total Premium$850 Number of Payments  10 =$85per payment

7. 10-6 Straight-Line Method Under the straight-line method, the total premium is amortized evenly over the life of the bonds: In this case: Total Premium$850 Number of Payments  10 =$85per payment In other words, every time Allen Company receives a $700 payment, they will only show $615 as revenue. Similarly, every time Locust Company makes a $700 payment, they will only show $615 as interest expense. The $85 difference will go to amortize the premium.

8. 10-7 Straight-Line Entries Allen Company Books Bond investment—Locust Sales Company………20,850 Cash……………………………………………..20,850 Cash………………………………………………….700 Bond Investment—Locust Sales Company…85 Interest Revenue……………………………….615

9. 10-8 Straight-Line Entries Allen Company Books Bond investment—Locust Sales Company………20,850 Cash……………………………………………..20,850 Cash………………………………………………….700 Bond Investment—Locust Sales Company…85 Interest Revenue……………………………….615 Locust Sales Company Books Cash…………………………………………………..20,850 Bonds Payable………………………………….20,000 Premium on Bonds Payable…………………..850 Interest Expense…………………………………….615 Premium on Bonds Payable……………………….85 Cash……………………………………………..700

10. 10-9 Amortization Table—Straight Line Interest Payment ABC Interest Received (3½% of Face Value) Premium Amortization ($850 x 1/10) Interest Revenue (A – B) 170085615 270085615 370085615 470085615 570085615 670085615 770085615 870085615 970085615 1070085615

11. 10-10 Amortization Table—Straight Line Interest Payment ABCD Interest Received (3½% of Face Value) Premium Amortization ($850 x 1/10) Interest Revenue (A – B) Unamortized Premium (D – B) $850 170085615765 270085615680 370085615595 470085615510 570085615425 670085615340 770085615255 870085615170 97008561585 10700856150

12. 10-11 Amortization Table—Straight Line Interest Payment ABCDE Interest Received (3½% of Face Value) Premium Amortization ($850 x 1/10) Interest Revenue (A – B) Unamortized Premium (D – B) Bond Carrying Value (E – B) $850$20,850 17008561576520,765 27008561568020,680 37008561559520,595 47008561551020,510 57008561542520,425 67008561534020,340 77008561525520,255 87008561517020,170 9700856158520,085 1070085615020,000

13. 10-12 Effective-Interest Method n Under the effective interest method, the amount of the premium amortized each period will be different. n The amortization amount will be less in the early periods and greater in the later periods over the life of the bonds. n The amortization computation in each period will be made using the effective interest rate. In this example, Allen Company bought the bonds to yield approximately 6% annually (or 3% every 6 months). n The computations are illustrated in the table on the next slide.

14. 10-13 Effective-Interest Method Interest Payment ABCDE Interest Received (3½% of Face Value) Interest Revenue (3% of Bond Carrying Value) Premium Amortization (A – B) Unamortized Premium (D – C) Bond Carrying Value (E – C) $850$20,850

15. 10-14 Effective-Interest Method Interest Payment ABCDE Interest Received (3½% of Face Value) Interest Revenue (3% of Bond Carrying Value) Premium Amortization (A – B) Unamortized Premium (D – C) Bond Carrying Value (E – C) $850$20,850 1$700$626 (.03 x $20,850)$7476620,766

16. 10-15 Effective-Interest Method Interest Payment ABCDE Interest Received (3½% of Face Value) Interest Revenue (3% of Bond Carrying Value) Premium Amortization (A – B) Unamortized Premium (D – C) Bond Carrying Value (E – C) $850$20,850 1$700$626 (.03 x $20,850)$7476620,766 2700$623 (.03 x $20,776)7769920,699

17. 10-16 Effective-Interest Method Interest Payment ABCDE Interest Received (3½% of Face Value) Interest Revenue (3% of Bond Carrying Value) Premium Amortization (A – B) Unamortized Premium (D – C) Bond Carrying Value (E – C) $850$20,850 1$700$626 (.03 x $20,850)$7477620,776 2700$623 (.03 x $20,776)7769920,699 3700$621 (.03 x $20,699)7962020,620 4700$619 (.03 x $20,620)8153920,539 5700$616 (.03 x $20,539)8445520,455 6700$614 (.03 x $20,455)8636920,369 7700$611 (.03 x $20,369)8928020,280 8700$608 (.03 x $20,280)9218820,188 9700$606 (.03 x $20,188)94 20,094 10700 $606 ($700 - $94)*94020,000 * Adjusted for rounding.

18. 10-17 Allen Company Books Bond investment—Locust Sales Company………20,850 Cash………………………………………………20,850 Effective-Interest Method

19. 10-18 Allen Company Books Bond investment—Locust Sales Company………20,850 Cash………………………………………………20,850 Cash………………………………………………….700 Bond Investment—Locust Sales Company…..74 Interest Revenue…………………………………626 Effective-Interest Method

20. 10-19 Allen Company Books Bond investment—Locust Sales Company………20,850 Cash………………………………………………20,850 Cash………………………………………………….700 Bond Investment—Locust Sales Company…..74 Interest Revenue…………………………………626 Cash…………………………………………………..700 Bond Investment—Locust Sales Company…...77 Interest Revenue…………………………………623 Effective-Interest Method

21. 10-20 Locust Sales Company Books Cash………………………………………………….20,850 Bonds Payable…………………………………..20,000 Premium on Bonds Payable……………………850 Effective-Interest Method

22. 10-21 Locust Sales Company Books Cash………………………………………………….20,850 Bonds Payable…………………………………..20,000 Premium on Bonds Payable……………………850 Interest Expense…………………………………….626 Premium on Bonds Payable……………………….74 Cash………………………………………………700 Effective-Interest Method

23. 10-22 Locust Sales Company Books Cash………………………………………………….20,850 Bonds Payable…………………………………..20,000 Premium on Bonds Payable……………………850 Interest Expense…………………………………….626 Premium on Bonds Payable……………………….74 Cash………………………………………………700 Interest Expense…………………………………….623 Premium on Bonds Payable……………………….77 Cash………………………………………………700 Effective-Interest Method

24. 10-23 End of Problem