CFA_C11.

qxd 11/6/03 3:06 PM Page 326

326 PART 2 • THE HOUSE OF ACCOUNTING

Lopakhin’s cash balance declines by a240,000 each year as interest is paid. However, the
impact on profit – via interest expense – is greater by the amount of the discount amortised in
the year. This is evident from the journal entries Lopakhin makes to record interest expense and
payment each year. Here are specimen entries for x2.

Interest accrual during x2

Dr. Interest expense (OE−) A349,300
Cr. Accrued interest payable (L+) A240,000
Cr. Bonds payable (L+) 109,300

Interest payment at end-December x2

Dr. Accrued interest payable (L−) A240,000
Cr. Cash (A−) A240,000

In our example, we’ve assumed that Lopakhin accounts for the bonds on a net basis. In
practice, the company would record ‘Bonds payable’ at their face value (i.e. a4 million) and
(unamortised) ‘Bond discount’ in a separate contra-liability account. In this case, the credit for
a109,300 in the above entry would be to ‘Bond discount’, thereby reducing the contra-liability.
Amortisation results in a zero balance in this account by the date the bonds mature. Full balance
sheet presentation of the bonds illustrates this:

Issuance End year

(In B000) Jan x1 x1 x2 x3 x4 x5
Bonds payable, at face value 4,000 4,000 4,000 4,000 4,000 4,000
Less:
Unamortised discount −606 −506.6 −397.3 −277 −144.7 0
Bonds payable, net of discount 3,394 3,493.4 3,602.7 3,723 3,855.3 4,000

One final point. Over debt’s lifetime, the impact, pre-tax, on cash and income should be the same.
Lopakhin’s 6% bonds demonstrate this. We can see from Exhibit 11.2 that Lopakhin’s cash bal-
ance is lower by a1,806,000 after the bonds’ redemption in x5. The company’s cumulative profits
are also lower by this amount. Of course, these calculations ignore the benefits – in cash and
profit terms – which Lopakhin enjoys from the property investment financed by the bonds.

l Other applications of interest method

The interest method can be used to amortise other types of financing cost. Debt issuance costs
is one. For example, suppose that Lopakhin incurs costs of a100,000 when issuing the 6% bonds
and thus the cash it receives in January x1 is a3.294 million, not a3.394 million. This increases
the effective interest rate on the bonds to 10.74%, as can be seen by solving for x in the follow-
ing equation:

(A240,000 × PVA (x%, 5 payments)) + (A4,000,000 × PV (x%, 5 periods)) = A3,294,000

Annual Principal
interest

Lopakhin records the issuance of the bonds in January x1 as follows:

Issuance of bonds in x1
Dr. Cash (A+) A3,294,000
Cr. Bonds payable (L+) A3,294,000