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Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 1

SUPPLEMENT C: A SIMPLIFIED APPROACH TO
BOND ACCOUNTING USING EFFECTIVE-INTEREST
AMORTIZATION

The approach shown in this supplement presents a simplified explanation of how bond liabilities
and interest expense are accounted for. You should be aware that this approach involves taking a
shortcut. While the shortcut will help you to focus on the line-items that ultimately are reported
on the financial statements, it requires that we ignore a few accounts that are typically used in
“real world” accounting systems. Be sure to check with your instructor (or course outline) to see
whether you are expected to read this supplement.
If you’re like most people, you probably have to really concentrate hard when reading about how
a reduction in a contra-liability account causes an increase in the carrying value of a bond. You
may even whisper this thought quietly to yourself a few times before it starts making sense. In
this section, we present a shortcut when accounting for bonds that will allow you to avoid
thinking in “double-negatives” like this. Hopefully it will also help you to stop whispering to
yourself when you read.
The shortcut involves simplifying only one aspect of what you studied earlier in this chapter.
Rather than record a discount or premium in a separate account, we will record it with the bonds
payable in an account that we will call Bonds Payable, Net. This name is used to remind you that
we are focusing on what is ultimately reported in the financial statements rather than what is
actually used “behind the scenes.” This shortcut greatly simplifies how we account for (1) the
initial bond issuance, (2) additional amounts owed to lenders for interest, (3) payments to the
lenders, and (4) removal of the bond liability when it is retired.
Accounting for Bonds Issued Below Face Value
1. Record the issuance of the bond and the receipt of cash. Let’s illustrate with the
example from the chapter in which Rogers issued bonds on January 1, 2007 for $93,376 cash.
The following journal entry would be used:

dr Cash (A). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,376
cr Bonds Payable, Net (L) . . . . . . . . . . . . . . . . . . . . . . . . 93,376
COACH'S
CORNER
If this example were to involve bonds
Assets  Liabilities  Shareholders’ Equity issued at a premium, the same journal
entry would be used, just with a different
Cash 93,376 Bonds Payable, Net 93,376 amount ($107,260 for the bond premium
example described in the chapter).

Rather than record the Bonds Payable at face value ($100,000), with an offsetting Discount on
Bonds Payable account (of $6,624), we have combined them together in an account called Bonds
Payable, Net (resulting in $93,376).
With this simplified approach, we still describe bonds as being issued at a discount or premium
because the recorded liability is either less or greater than the face value. What has changed,
though, is that we no longer need a separate discount or premium account to adjust from the face
value to the true liability. Instead, the true liability is reported directly in Bonds Payable, Net.
2. Record any interest owed by the end of the accounting period. One of the
advantages of this simplified approach is that we no longer choose between the straight-line or
effective-interest method of amortization because there is no discount or premium account to
amortize. An additional advantage is that interest expense is calculated directly, using an interest
formula similar to what you learned earlier:

Interest  Amount Owed  Interest Rate  Time

The amount owed is the cash that was received when the bond was issued plus any unpaid
interest cost. With the simplified approach, the amount owed is the balance in the Bonds

470 Assets  Liabilities  Shareholders’ Equity Interest Payable 6.000 (interest payment). .846 1/1/08 December 31. . 2007. . . . . 2007. . 6. . . .587. The rate of interest is the market interest rate that was actually used to determine the present value of the bond when it was issued.470 in Bonds Payable. . . . Interest expense is calculated by multiplying the amount owed at the beginning of the interest period times the 93. . .000 Interest Expense (E) 7. .470 was added to the Bonds Payable. . . . . . . Bonds Payable. 6.000 Let’s look at the entries that will be made at the end of the next year. . . . .846 (amount owed)  8% (market interest rate)  12/12 (time)  $7. . 2008. . . . . . . Net (L) Record any interest owed by the end of the accounting period. . . . . . . . .000 Assets  Liabilities  Shareholders’ Equity Cash 6. Notice that Rogers is going to pay only $6. . 2 Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization Payable. This would be recorded on December 31.470 Bonds Payable. . From this. 6. . This would be pay this amount at maturity. 2008. . . From the face of the bond we can calculate the amount of interest to be paid for this period as: $100.376 1/1/07 market interest rate for the year. Rogers would record dr Interest Payable (L) . . . . . with the following adjusting journal entry: . . . .000 (face value)  6% (stated interest rate)  12/12 (time)  $6. . . . . . dr Interest Expense (E. . Net 1. COACH'S CORNER Notice that Rogers is going to pay only $6. with the following adjusting journal entry: the face value of the bond.000 when its true interest expense is $7. . . Net account on 94. .000).470 3.587. Net liability will increase by Recording the $1. . . 2007. . the amount owed increased to $94. The amount owed at the beginning of 2008 is shown in the T- 1. . . . . When interest is paid on January 1. . . . . This interest expense differs from what Rogers actually promised to pay. . . . . . .000 cr Cash (A) . . its Bonds Payable. . . After the $1. . as part of recorded on December 31. . SE) . . . . . we calculate the interest expense as $93. . . Net liability increases by the amount of interest expense that Rogers isn’t going to pay in this interest period ($1. .470 12/31/07 account in the margin. . . . . . . . The amount of interest payable is based on what Rogers actually promised to pay ($6. . Because the company pays less than the cost of interest. . Net account at the beginning of the interest period. Net (L) . . . 2007. . Net is appropriate because Rogers will the amount of interest expense that won’t be paid this interest period ($1. From this. Because the company pays less than the cost of interest. .000 Interest Payable 6. The amount owed at the beginning of this period is the $93. . .846.000 cr Bonds Payable. .470. . . .376 (amount owed)  8% (market interest rate)  12/12 (time)  $7. .000 when its true interest expense is $7.470 (interest expense). . we can calculate the interest expense for 2008 as: $94. . . . . . . Record payments made to the lender.587).470). . . . . . . . . . . . . . . Net account on January 1.470 cr Interest Payable (L) . . 1. Let’s illustrate by recording interest owed for the first annual interest period ended December 31. . . . its Bonds Payable.376 reported in the Bonds Payable. 7.

000 cr Bonds Payable. .                     Recorded during each period with the following entry: dr Interest Expense (E. . . . . . . Net (L) . . . . . . . . . . Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 3 dr Interest Expense (E. .000 Interest Expense (E) 7. . . . 2011). . .852 100. . . C. . . . . . . . (C) cr Bonds Payable.433  Reported on the balance 12/31/09 96. (D) . . . . . . . .587 COACH'S CORNER The interest expense for 2008 is greater than that for 2007 because the balance in Bonds Payable. 6. . we present a bond amortization schedule that summarizes the balance in Bonds Payable. SE). .148  sheet at the 12/31/10 98. As before. . . Interest expense (column B) is calculated by multiplying the amount owed at the beginning of the interest period (column A) times the market interest rate times the length of period.587 Bonds Payable. 7.000 Assets  Liabilities  Shareholders’ Equity Cash 6. . . Interest payable (column C) is calculated as the face value times exhibit 10C. . . 1. . .846 96. .000 These journal entries for interest expense and interest payments will continue as long as the bonds remain outstanding.470 1. Notice in column E that as the bonds approach maturity (January 1. . . . . the Bonds Payable. . . .000 Interest Payable 6.148  period. . . . in the first row. .587 6. 7. .715 6. . . In Exhibit 10C. . Net 12/31/07 12/31/08 93. . . . . .587 cr Interest Payable (L) . . . .000 1. . . . . . (B) cr Interest Payable (L). . . 6. . the changes that occur during each interest period (columns B. Net (L).846  Used to calculate interest expense 7. . . Net account approaches the face value of the bonds. . with the balance in Bonds Payable. although the amounts will change as the Bonds Payable. . . . .1 Bond Amortization Schedule BEGINNING END OF OF PERIOD CHANGES DURING THE PERIOD PERIOD (A) (B) (C) (D)  (B)  (C) (E)  (A)  (D) Period Bonds Interest Interest Interest Added to Bonds Ended Payable. Net at the beginning of each interest period (column A).587 Record payments made to the lender. . .000 6. . the following journal entry is required: dr Interest Payable (L) . .715 98. . when Rogers pays interest on January 1. . . . .1. . . . . . . . . Net was greater in 2008 Assets  Liabilities  Shareholders’ Equity than 2007. The amortization schedule begins. .852 6. . . . . . . . . . . . .376 94. . . Interest Payable 6.000  end of each period. SE) . . . 6.587 94. .000 cr Cash (A) . . . Net Expense Payable Bonds Payable Payable. and D). Net immediately after the bond issuance. . . . Net balance at the end of each period (column E). . . . . 2009. . . Net balance changes. .433  for each interest 7. . . . Net 1. .470 7. . . and the Bonds Payable. . .000 1. . . .000 1. .

. . The stated interest payment for the year is $6. . And. . the balance sheet of Buchheit Enterprises reported $95.000 in a liability called “Bonds payable. .000  6%  12/12). . . which involved a four-year bond (with a face value of $100. This price implies a market interest rate of 4%. . . .260. SE) . 4. . as we saw before. .290. .710 cr Interest Payable (L) . Assuming that interest is paid each January 1. . which is the starting point for calculating interest expense in that year. . (Supplement C) How is interest expense calculated using the simplified approach to the effective-interest method for a bond issued at (a) a discount and (b) a premium? MINI-EXERCISES LO4 M10-S1 (Supplement C) Recording Interest Accrual and Interest Payment (Simplified Approach to Effective-Interest Amortization) On December 31. and (b) payment of the interest on January 1. . . prepare separate journal entries to record (a) accrual of interest on December 31. .000 and stated interest rate of 6%) that was issued at a price of $107. . 1. . . Net (column E) is the beginning balance (column A) plus the unpaid interest (column D). . these entries to record interest expense and payments will continue each period until the bond matures or is retired early. Net. . using the simplified approach shown in chapter supplement C. . 6. . . . .290 ($107. Unpaid interest (column D) is the difference between the interest expense (column B) and the interest payment that will be made (column C). 2007. . . .000 interest payment is made on January 1. . . . . . interest expense is less than the promised cash payment for each interest period.000 bond with a stated interest rate of 5 percent that was issued when the market interest rate was 6 percent. . . EXERCISES LO4 E10-S1 (Supplement C) Recording the Effects of a Premium Bond Issue and First Interest Payment (Simplified Approach to Effective-Interest Amortization) Refer to the information in E10-8 and assume Grocery Corporation accounts for the bond using the shortcut approach shown in chapter Supplement C. . . . . . . . .4 Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 4 the stated interest rate times the length of period. . . . which is greater than the interest expense of $4. . . . The extra amount included in each payment goes to paying down Bonds Payable. . which is recorded with the following journal entry: dr Interest Expense (E. . . The ending balance in Bonds Payable. The only difference is that because a premium reduces the cost of borrowing. . . .000 When the $6. . . . . .” This liability related to a $100. Accounting for Bonds Issued above Face Value The calculations and journal entries used to record interest expense and interest payments when a bond issues at a premium are similar to those shown in the previous section for a bond issued at a discount. so the interest expense for the first year is $4. The ending balance for one year (column E) then becomes the beginning balance for the next year (column A).260  4%  12/12). . 2009. To illustrate. . . . . net. we extend the bond premium example introduced earlier in the chapter. . . Net (L) .710 included in the payment represents a repayment of the bond liability.000 ($100. 2008. FOR YOUR PRACTICE QUESTIONS 1. Interest Payable will be debited and Cash will be credited. . .290 dr Bonds Payable. The extra $1. . . . . .

Prepare the journal entry to record the interest accrual on December 31. Prepare the journal entry to record the bond issuance. x e cel COACHED PROBLEMS CP10-S1 (Supplement C) Recording Bond Issuance and Interest Payments (Simplified LO4 Approach to Effective-Interest Amortization) Complete the requirements of CP10-7.710 Required: 1. 2. Net 1.000 Interest Expense (E) 4.290 Bonds Payable. Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 5 Assets  Liabilities  Shareholders’ Equity Interest Payable 6. 2007. 3. 2007. Required: 1.1. E10-S1 (Supplement C) Recording the Effects of a Discount Bond Issue and First LO4 Interest Payment and Preparing a Discount Amortization Schedule (Simplified Approach to Effective-Interest Amortization) Refer to the information in E10-12 and assume Seton Corporation accounts for the bond using the shortcut approach shown in chapter Supplement C. for the simplified approach. Prepare a bond discount amortization schedule for these bonds. 2.1. shown in Exhibit 10C. assuming West Company uses the simplified approach shown in chapter supplement C. using the format shown in Exhibit 10C. SIMPLIFY WITH SPREADSHEETS SS10-S1 (Supplement C) Preparing a Bond Amortization Schedule (Simplified LO4 Approach to Effective-Interest Amortization) Refer to the information in SS10-1 and prepare a worksheet that reproduces the bond discount amortization schedule. Prepare the journal entry to record the interest payment on December 31. . Prepare the journal entry to record the bond issuance.