The journal entry to record 2010 interest revenue on 12/31/10 is Cash ($400,000 9%) 36,000 Inv.

. in bonds 1,560 Int. revenue 37,560 Journal Entries The issuers books will be illustrated at gross (including a premium or discount account) and the investors books will be illustrated at net (no discount or premium account). The investor may record the bonds either net or gross, but the issuer records at gross. In the past, CPA examination problems and solutions have followed the net method on the books of the investor.
a. b. c. Issue and Acquisition First int. Payment Premium-Amortization Issuer Cash Bonds pay. Bonds prem. Interest exp. Cash Bond prem. Interest exp. 10,514 10,000 514 300 300 37.15* 37.15 Investor Bond invest. Cash Cash Interest rev. Interest rev. Bond invest. 10,514 10,514 300 300 37.15 37.15*

*Interest receipt (payment) minus effective interest = 300 262.85 = 37.15 Effective interest = net book value times effective rate = 10,514 .025 = 262.85

Entry a. assumes that the bonds are issued on the interest payment date. If bonds are purchased between interest payment dates, the purchaser will also include accrued interest through the purchase date in the total cash paid for the bonds. The payment of this accrued interest on the purchase date will serve to reduce the subsequent receipt of interest income (which covers a time period longer than the time the purchaser held the bond). Subsequent interest payments are recorded the same as entry b. shown above. The amount of subsequent amortization (entry c. above) changes. Interest to be recorded under the interest method is always computed by Effective interest rate Net book value This formula is true of all applications of the interest method. The effective rate of interest times net book value is the actual interest revenue or expense for the period. The difference between the actual interest and the amount received or paid is the amortization. The amortization table below shows the effective interest amounts and premium amortizations for the first 4 periods.
Period 0 1 2 3 3% cash interest $300(a) 300 300 2 1/2% effective interest $262.85(b) 261.92 260.97 Decrease in book value $37.15(c) 38.08 39.03 Book value of bonds $10,514.00 10,476.85(d) 10,438.77 10,399.74

300

259.99

40.01

10,359.73

(a) 3% $10,000 (c) $300 $262.85 (b) 2 1/2% $10,514.00 (d) $10,514.00 $37.15

Since the interest is paid semiannually, interest (including premium amortization) is recorded every 6 months. The journal entries for periods 2, 3, and 4 are
Issuer Period 2 Period 3 Period 4 Interest expense Bond premium Cash Interest expense Bond premium Cash Interest expense Bond premium Cash 261.92 38.08 300.00 260.97 39.03 300.00 259.99 40.01 300.00 Investor Cash 300.00 Interest rev. 261.92 Bond invest. 38.08 Cash 300.00 Interest rev 260.97 Bond invest. 39.03 Cash 300.00 Interest rev. 259.99 Bond invest 40.01

Notice that the interest (revenue and expense) decreases over time. This is because the net book value (which is also the present value) is decreasing from the maturity value plus premium to the maturity value. Thus, the effective rate is being multiplied by a smaller amount each 6 months. Also, note that the change in interest each period is the prior periods premium amortization times the effective rate. For example, the interest in period 3 is $.95 less than in period 2, and $38.08 of premium was amortized in period 2. The effective rate of 2.5% (every 6 months) times $38.08 is $.95. Thus, if the interest changes due to the changing level of net book value, the change in interest will be equal to the change in the net book value times the effective rate of interest. Another complication may arise if the year-end does not coincide with the interest dates. In such a case, an adjusting entry must be made. The proportional share of interest payable or receivable should be recognized along with the amortization of discount or premium. The amortization of discount or premium should be straight-line within the amortization period.
EXAMPLE: Assume that in the above example, both issuer and investor have reporting periods ending 3 months after the issuance of the bonds. Issuer Interest expense Interest payable Bond premium Interest expense Investor Interest receivable Interest revenue Interest revenue Bond investment

Entries on the closing date

150 150 18.57 18.57

150 150 18.57 18.57

Reverse at beginning of new period and make regular entry at next interest payment date. If bonds are sold (bought) between interest dates, premium/discount amortization must be computed for the period between sale (purchase) date and last (next) interest date. This is accomplished by straight-lining the 6-month amount which was calculated using the effective interest method.

EXAMPLE: The investor sold $5,000 of bonds in the above example, 2 months after issuance, for $5,250 plus interest. 1. The bond premium which must be amortized to the point of sale ($5,000 for 2 months) is 1/2 x 1/3 x $37.15 or $6.19. Interest revenue 6.19 Investment 6.19 The sale is recorded. The investment account was $5,257 before amortization of $6.19. The cash received would be $5,250 plus $50 interest (1/2 x 1/3 x $300). The loss is a forced figure. Cash 5,300.00 Loss .81 Interest revenue 50.00 Investment 5,250.81 Check the interest revenue recorded ($50.00 $6.19) to the interest earned: $5,257 x 2 1/2% x 1/3 (which equals $43.81).

2.

3.

Costs incurred in connection with the issuance of bonds (e.g., printing and engraving, accounting and legal fees, and commissions), according to SFAC 6, may be treated two ways. However, ASC 835-30-45-3 currently allows the treatment of bond issue costs only in one of these ways. SFAC 6 states that the bond issue costs can be treated as either an expense or a reduction of the related bond liability. Bond issue costs are not considered as assets because they provide no future economic benefit. The argument for treating them as a reduction of the related bond liability is that they reduce bond proceeds, thereby increasing the effective interest rate. Thus, they should be accounted for the same as unamortized discounts. In practice, however, the only acceptable GAAP for bond issue costs is to treat them as deferred charges and amortize them on a straight-line basis over the life of the bond.