Question

In: Accounting

Please read and respond to the three questions below. Please comment or respond to at least...

Please read and respond to the three questions below. Please comment or respond to at least two of your classmates in addition to your initial post. Do not forget to cite your sources.

1. Under what conditions of bond issuance does a discount on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?

2. How should discount on bonds payable be reported on the financial statements? Premium on bonds payable?

3. What are the two methods of amortizing discount and premium on bonds payable? Explain each.

Solutions

Expert Solution

1. Answer

Discount on bonds payable occurs when a bond's stated interest rate is less than the bond market's interest rate.

If a $1,000,000 bond issue promises to pay interest of 8% per year and the bond market demands 8.125%, the bonds will sell for less than $1,000,000. The difference between the $1,000,000 of face value and the amount the bond market is willing to pay is the discount on bonds payable.

The amount of the discount is a function of 1) the number of years before the bonds mature, and 2) the difference in the bond's stated interest rate and the market's interest rate.

Premium on bonds payable (or bond premium) occurs when bonds payable are issued for an amount greater than their face or maturity amount. This is caused by the bonds having a stated interest rate that is higher than the market interest rate for similar bonds.

To illustrate the premium on bonds payable, let's assume that a corporation prepares to issue bonds with a maturity amount of $10,000,000 and a stated interest rate of 6%. However, when the 6% bonds are actually sold, the market interest rate is 5.9%. Since the bonds will be paying investors more than the interest required by the market ($600,000 instead of $590,000 per year), the investors will pay more than $10,000,000 for the bonds. If we assume the investors pay $10,150,000 for the bonds, the corporation will record the transaction with a debit to Cash of $10,150,000; a credit to Bonds Payable of $10,000,000 and a credit of $150,000 to Premium on Bonds Payable (an adjunct liability account).

Over the life of the bonds, the $150,000 premium is to be accounted for as a reduction of the corporation's interest expense. This is done through the amortization of premium on bonds payable.

The combination of 1) the unamortized credit balance in the account Premium on Bonds Payable, 2) the unamortized debit balance in the account Bond Issue Costs, and 3) the $10,000,000 credit balance in Bonds Payable is known as the book value or the carrying value of the bonds payable

2.answer

The premium or discount on bonds payable is the difference between the amount received by the corporation issuing the bonds and the par value or face amount of the bonds. If the amount received is greater than the par value, the difference is known as the premium on bonds payable. If the amount received is less than the par value, the difference is known as the discount on bonds payable.

The premium and discount accounts are viewed as valuation accounts. The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable.

The premium or discount is to be amortized to interest expense over the life of the bonds. Hence, the balance in the premium or discount account is the unamortized balance.

Where the Premium or Discount on Bonds Payable is Presented
The premium or the discount on bonds payable that has not yet been amortized to interest expense will be reported immediately after the par value of the bonds in the liabilities section of the balance sheet. Generally, if the bonds are not maturing within one year of the balance sheet date, the amounts will be reported in the long-term or noncurrent liabilities section of the balance sheet

3. answer

Two methods to amortize discount or premium on bonds are : -

(a) Straight line method

(b) Effective interest rate method

According to the straight-line method, the amount of the premium amortized in each year will be the same. To compute it, we have to divide the bond premium by the number of years.

According to the effective interest rate method, the adjustment reflects the reality better. In other words, it reflects what the change in the bond price would be if we assumed that the market discount rate doesn’t change.

To apply the effective interest rate method, let’s first calculate the bond price at issuance. then, wewill compute the interest payment. In each year

Note, however, that the interest expense will be different in each year. The interest expense in a given period is equal to the effective interest rate at the time of issuing bonds multiplied by the carrying amount at the beginning of the period.

Summary

As you can see, according to the straight-line method the amortization of premium is the same for all periods. However, for the effective interest rate method, the amortization of premium is greater as time passes by


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