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27 February, 13:11

Cash interest is computed annually when a bond is issued for other than its face value. For a bond issued at a premium, how will this component change under the effective interest method as the bond approaches maturity?

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  1. 27 February, 15:33
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    Under the effective interest method, as a bond approaches maturity, the interest expense decreases while the amortization of the bond premium increases.

    Explanation:

    E. g. a company issues $800,000 in 8% bonds when the market rate is 7%, so the bonds price is $856,850 (semiannual coupons are paid).

    Journal entry to record the issuance

    Dr Cash 856,850

    Cr Bonds payable 800,000

    Cr Premium on bonds payable 56,850

    amortization of bond premium on first coupon payment:

    ($856,850 x 3.5%) - ($800,000 x 4%) = $29,989.75 - $32,000 = - $2,010.25 ≈ - $2,010

    Journal entry to record first coupon payment:

    Dr Interest expense 29,990

    Dr Premium on bonds payable 2,010

    Cr Cash 32,000

    amortization of bond premium on second coupon payment:

    ($854,840 x 3.5%) - ($800,000 x 4%) = $29,919.40 - $32,000 = - $2,080.60 ≈ - $2,081

    Journal entry to record second coupon payment:

    Dr Interest expense 29,919

    Dr Premium on bonds payable 2,081

    Cr Cash 32,000
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