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

Payable, Net account at the beginning of the interest period. 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.
Let’s illustrate by recording interest owed for the first annual interest period ended December 31,
2007. The amount owed at the beginning of this period is the $93,376 reported in the Bonds
Payable, Net account on January 1, 2007. From this, we calculate the interest expense as

$93,376 (amount owed)  8% (market interest rate)  12/12 (time)  $7,470

(interest expense).

This interest expense differs from what Rogers actually promised to pay. From the face of the
bond we can calculate the amount of interest to be paid for this period as:

$100,000 (face value)  6% (stated interest rate)  12/12 (time)  $6,000

COACH'S
CORNER
Recording the $1,470 in Bonds Payable,
Net is appropriate because Rogers will
pay this amount at maturity, as part of
the face value of the bond.
(interest payment).
Notice that Rogers is going to pay only $6,000 when its true interest expense is $7,470. Because
the company pays less than the cost of interest, its Bonds Payable, Net liability will increase by
the amount of interest expense that won’t be paid this interest period ($1,470). This would be
recorded on December 31, 2007, with the following adjusting journal entry:

dr Interest Expense (E, SE) . . . . . . . . . . . . . . . . . . . . . . . . . 7,470

cr Interest Payable (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
cr Bonds Payable, Net (L) . . . . . . . . . . . . . . . . . . . . . . . . 1,470

Assets  Liabilities  Shareholders’ Equity

Interest Payable 6,000 Interest Expense (E) 7,470
Bonds Payable, Net 1,470

3. Record payments made to the lender. When interest is paid on January 1, 2008,
Rogers would record

dr Interest Payable (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

cr Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Assets  Liabilities  Shareholders’ Equity

Cash 6,000 Interest Payable 6,000

Let’s look at the entries that will be made at the end of the next year.
Bonds Payable, Net (L) Record any interest owed by the end of the accounting period. Interest expense is
calculated by multiplying the amount owed at the beginning of the interest period times the
93,376 1/1/07 market interest rate for the year. The amount owed at the beginning of 2008 is shown in the T-
1,470 12/31/07 account in the margin. After the $1,470 was added to the Bonds Payable, Net account on
94,846 1/1/08 December 31, 2007, the amount owed increased to $94,846. From this, we can calculate the
interest expense for 2008 as:
$94,846 (amount owed)  8% (market interest rate)  12/12 (time)  $7,587.

The amount of interest payable is based on what Rogers actually promised to pay ($6,000).
Notice that Rogers is going to pay only $6,000 when its true interest expense is $7,587. Because
the company pays less than the cost of interest, its Bonds Payable, Net liability increases by the
amount of interest expense that Rogers isn’t going to pay in this interest period ($1,587). This
would be recorded on December 31, 2008, with the following adjusting journal entry:
 Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 3

dr Interest Expense (E, SE) . . . . . . . . . . . . . . . . . . . . . . . . . 7,587

cr Interest Payable (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
cr Bonds Payable, Net (L) . . . . . . . . . . . . . . . . . . . . . . . . 1,587 COACH'S
CORNER
The interest expense for 2008 is greater
than that for 2007 because the balance in
Bonds Payable, Net was greater in 2008
Assets  Liabilities  Shareholders’ Equity
than 2007.
Interest Payable 6,000 Interest Expense (E) 7,587
Bonds Payable, Net 1,587

Record payments made to the lender. As before, when Rogers pays interest on January 1,
2009, the following journal entry is required:

dr Interest Payable (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

cr Cash (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Assets  Liabilities  Shareholders’ Equity

Cash 6,000 Interest Payable 6,000

These journal entries for interest expense and interest payments will continue as long as the bonds
remain outstanding, although the amounts will change as the Bonds Payable, Net balance changes.
In Exhibit 10C.1, we present a bond amortization schedule that summarizes the balance in Bonds
Payable, Net at the beginning of each interest period (column A), the changes that occur during
each interest period (columns B, C, and D), and the Bonds Payable, Net balance at the end of
each period (column E). Notice in column E that as the bonds approach maturity (January 1,
2011), the Bonds Payable, Net account approaches the face value of the bonds.
The amortization schedule begins, in the first row, with the balance in Bonds Payable, Net
immediately after the bond issuance. 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. Interest payable (column C) is calculated as the face value times

exhibit 10C.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 Expense Payable Bonds Payable Payable, Net

12/31/07
12/31/08
93,376
94,846  Used to calculate
interest expense
7,470
7,587
6,000
6,000
1,470
1,587
94,846
96,433  Reported on
the balance
12/31/09 96,433  for each interest 7,715 6,000 1,715 98,148  sheet at the
12/31/10 98,148  period. 7,852 6,000 1,852 100,000  end of each
period.





















Recorded during each period with the following entry:

dr Interest Expense (E, SE). . . . (B)

cr Interest Payable (L). . . . . . (C)
cr Bonds Payable, Net (L). . . (D)
4 Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 4

the stated interest rate times the length of period. Unpaid interest (column D) is the difference
between the interest expense (column B) and the interest payment that will be made (column
C). The ending balance in Bonds Payable, Net (column E) is the beginning balance (column A)
plus the unpaid interest (column D). The ending balance for one year (column E) then becomes
the beginning balance for the next year (column A), which is the starting point for calculating
interest expense in that year.
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. The only difference is that because a premium reduces the cost of borrowing, interest
expense is less than the promised cash payment for each interest period. The extra amount
included in each payment goes to paying down Bonds Payable, Net. To illustrate, we extend the
bond premium example introduced earlier in the chapter, which involved a four-year bond (with
a face value of $100,000 and stated interest rate of 6%) that was issued at a price of $107,260.
This price implies a market interest rate of 4%, so the interest expense for the first year is $4,290
($107,260  4%  12/12). The stated interest payment for the year is $6,000 ($100,000  6%
 12/12), which is greater than the interest expense of $4,290. The extra $1,710 included in the
payment represents a repayment of the bond liability, which is recorded with the following
journal entry:

dr Interest Expense (E, SE) . . . . . . . . . . . . . . . . . . . . . . . . . 4,290

dr Bonds Payable, Net (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,710
cr Interest Payable (L) . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

When the $6,000 interest payment is made on January 1, Interest Payable will be debited and
Cash will be credited. And, as we saw before, these entries to record interest expense and
payments will continue each period until the bond matures or is retired early.

FOR YOUR PRACTICE

QUESTIONS
1. (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, 2007, the balance sheet of Buchheit Enterprises reported $95,000 in a liability
called “Bonds payable, net.” This liability related to a $100,000 bond with a stated interest rate of
5 percent that was issued when the market interest rate was 6 percent. Assuming that interest is
paid each January 1, prepare separate journal entries to record (a) accrual of interest on December
31, 2008, and (b) payment of the interest on January 1, 2009, using the simplified approach shown
in chapter supplement C.

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.
 Supplement C: A Simplified Approach to Bond Accounting Using Effective-Interest Amortization 5

Assets  Liabilities  Shareholders’ Equity

Interest Payable 6,000 Interest Expense (E) 4,290
Bonds Payable, Net 1,710

Required:
1. Prepare the journal entry to record the bond issuance.
2. Prepare the journal entry to record the interest accrual on December 31, 2007.

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.

Required:
1. Prepare the journal entry to record the bond issuance.
2. Prepare the journal entry to record the interest payment on December 31, 2007.
3. Prepare a bond discount amortization schedule for these bonds, using the format shown in
Exhibit 10C.1.

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, shown in Exhibit 10C.1, for the simplified approach.
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, assuming West Company uses the simplified approach
shown in chapter supplement C.