Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 10 Liabilities 455

Bond Discount Amortization

Because a bond discount increases the effective interest rate of the bond issue, the dis-

count must be reflected in the bond’s periodic interest expense. This is accomplished

through amortization of the bond discount. Amortization allocates a portion of the

bond discount to each interest payment period, increasing periodic interest expense to

reflect the higher market rate of interest at which the bonds were issued.

The two methods of amortizing a bond discount or premium are (1) the straight-

line methodand (2) the effective interest rate method, often called the interest

method.^5 Both methods amortize the same total amount of discount over the life of the

bonds. The interest method is required by generally accepted accounting principles.

However, the straight-line method is acceptable if the results obtained do not materi-

ally differ from the results that would be obtained by using the interest method.

Because the straight-line method illustrates the basic concept of amortizing discounts

and is simpler, we will use it in this chapter.

The straight-line method allocates the same amount of bond discount to each pe-

riod. Applying this method to the preceding example yields amortization of^110 – of

1/1 6/30

Year 2007 Year 2011

12/31 12/31

$100,000

Face

Amount

$6,000

Interest (6%)

Semiannual

Contract Rate

$6,000

Interest (6%)

Semiannual

Contract Rate

$6,000

Interest (6%)

Semiannual

Contract Rate

$6,000

Interest (6%)

Semiannual

Contract Rate

$53,273

$43,133

Semiannual Market Rate  6.5%

6/30

Present Value of Face Amount

Present Value of Interest Payments

$100,000 Present Value of $16%,n 10 (0.53273)

$6,000 Present Value of an Annuity of $1

(7.18883)

6%,n 10

Exhibit 12

Present Value of Bonds
Issued at Discount

Present value of face amount of $100,000 due in 5 years, at 13%

compounded semiannually: $100,000 0.53273 (present value of

$1 for 10 periods at 6.5%)........................................... $53,273

Present value of 10 semiannual interest payments of $6,000 at

13% compounded semiannually: $6,000 7.18883 (present value of

annuity of $1 for 10 periods at 6.5%)................................... 43,133

Total present value of bonds......................................... $96,406

5 The interest method is discussed in the appendix to this chapter.