BA 318 Ch 13 in class example 6

Professor Hawley: So, um, let's go ahead,
we'll just work on this together.

Um, it says, presented below are two
independent situations.

So, George Gershwin Company sold
$2,000,000 of 10%, 10-year bonds at 104

on January 1st of '25.

The bonds were dated January 1st of '25.

Okay, that was probably a repeat.

And, pay interest on July 1st and
January 1st.

If Gershwin uses the straight line method
to amortize bond premium or discount,

determine the amount of interest expense
to be reported on July 1st '25 and

December 31st of '25.

Alright, well what I would like to do is
start with the entry that would have been

recorded when they issued the bond,
just so that we can kind of get that on

paper so we can see it.

So, we have-- the bonds were issued.

This would be-- the $2 million would be
the face value.

And, 10% would be, what?

The stated rate, okay.

It's a 10-year bond.

It was issued at 104, so that means that
it was issued at a premium.

They're dated January 1st and they pay
interest twice per year, so how many

interest payment periods would
there be in this bond?

20, right, 'cause it's 10 years, they pay
interest twice per year.

So, because they are using the straight
line method, we would say there is

20 interest payment periods.

Okay, so on 1/1 when they issue the bonds,
how much cash would they receive?

Debit cash for the face value of
$2 million times 1.04.

And that would be a cash receipt
of $2,080,000.

And then, how much did they need to pay
back at the end?

They're going to credit bonds payable
for always the face value, right?

$2 million.

Alright, and we clearly said this was
issued at a premium, so we know

just by looking at this, to balance our
entry, we're going to have to credit

$80,000 credit to premium on bonds--
I'll just put BP-- bonds payable.

So, if you get confused ever on what is
the premium or is it a premium or a

discount, look at your journal entry and
see where it needs to go.

It needs to be a credit or a debit.

So, in this case, it needs to be a credit,
and we know that a premium on

bonds payable has a normal credit balance.

It's an adjunct account, meaning it comes
alongside the bond payable, it actually

increases the bond payable.

Where as, the discount on bonds payable
is a contra-account.

It is the opposite, so it's a debit.

Normal debit balance, and it's going to
subtract, or it's going to reduce that bond payable.

Okay, so, the premium is $80,000 and we
determined that we're going to divide that

by 20, that's the number of interest
payment periods.

And that would be $4,000 per
interest payment period.

Okay, so we're-- the question is asking
us to determine the interest expense

to be reported on July 1 and
December 31st.

So, let's just do it in the form of a
journal entry.

So on July 1 of '25, how much, um--
the question is, in this case, if we're

doing the straight line amortization,
we know that we're going to debit

interest expense, but with straight line
amortization, the interest expense is

the plug number, okay?

We are going to credit cash because
we're actually paying interest out,

and at what rate are we paying
interest out?

So, 10% for 6 out of 12 months, right?

So, it's at the stated rate.

So we say, the face value of $2 million
times the stated rate of 10 % times

the time, which is 6 out of 12 months.

Which would be the same thing as
saying 5%, right?

Um, so the cash being paid out, if we do
the math there, cash being paid out is $100,000.

And, we need to amortize that discount--
sorry, excuse me, premium.

And we determined that each interest
period we're going to amortize the

premium by $4,000.

Now, remember, the premium has a credit
balance, so to amortize it, I need to

debit it.

So, I'm going to debit premium on
bonds payable $4,000.

And then, the difference between what we
paid in cash and the premium that we

amortized is going to be our
interest expense.

So, $96,000.

So, you can also think of it as when you
issue bonds at a discount, the interest

expense-- sorry, premium-- the interest
expense per period is reduced.

Why? Because you received more
cash up front, so the amount that you're--

you're paying interest on a smaller face
value, but you received more cash.

So, it's effectively reducing your
interest rate because you received

more cash up front.

And then on 12/31, the entry
would be similar.

We're going to debit interest expense.

We're going to debit premium on
bonds payable.

And that's going to be at that same
straight line rate, so that's $4,000.

And then, we're going to credit-- and
this one is payable on January 1st.

So, we're going to credit interest payable
$100,000.

And again, the interest expense
is going to remain the same at $96,000.

Alright, let's do part B then.

Um, Ron Kenoly Inc. issued $600,000
9%, 10-year bonds on June 30th of '25

for $562,500.

This price provides a yield of 10%.

Okay, so we have 2 different interest rates.

9% is, what?

9% is the stated rate,
and 10% is the market rate,

or the effective rate.

Interest is payable semiannually
on December 31st and June 30th.

If Kenoly uses the effective interest
method, determine the amount of

interest expense to record if financial
statements are issued on October 31st of '25.

So, this one's a little more-- it's got a
little more different things going on here.

So, not only are we using the effective
method, but we are also only calculating

interest expense through October 31st.

Okay, so first, again, let's go ahead and
record the issuance of the bonds.

They issued the bonds on 6/30,
and they're going to debit cash.

They said they received-- they told us
how much they received-- $562,500.

And, we're going to record a credit to
bonds payable always for the face value,

which is $600,000.

Which means they recorded those bonds
at a discount.

And so, we're going to debit discount on
bonds payable for $37,500.

That's going to balance our entry, right?

Alright, now, assuming that we are going
to issue financial statements on September 31st,

what do we need to do?

We need to make sure that those financial
statements are up to date with regard to

interest expense and interest payable.

How much do we owe at that time?

So, on 10/31/25, we're going to debit
interest expense.

And, how much interest expense
would there have been?

How do we calculate using the effective
method--the effective interest method?

Well, if we look-- if we net together the
discount and the bonds payable,

we'll see that the carrying value of the
loan is $562,500 as of 6/30.

So, when we say that's our debt
outstanding from 6/30 to 12-- excuse me,

to October 31st.

So, all of July, August, September,
October, so 4 months, um, interest

has been accruing.

So if we take this to calculate our
interest expense using the effective rate,

we're going to say times the effective
rate of 10%, or the yield rate.

But then also, times 4 out of 12 because
it's only 4 months that has passed by.

So, we're going to debit interest expense
by $562,500 times 10% times 4/12.

That would be $18,750, okay.

And then, we're going to credit interest
payable, and this is going to represent, what?

How much cash we have due at this moment.

And so, how do you think we would
calculate the interest payable?

So for interest payable, it's just the
cash that we would pay if we had to pay

right now would be the face value times
the stated rate times time.

So in this case, the face value is
$600,000 times the stated rate, which

is 9%, times 4 out of 12.

And so, if we do the math there, that's
$18,000.

Now remember, when we use the effective
interest method, what is the plug?

The plug number is the discount or
premium amortization.

So, here we have a discount, we're
amortizing it, so we're going to credit it

to make it smaller-- discount on bonds
payable, the difference is going to be

$750, so that's going to be
our amortization, okay.