Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2017, when the market interest rate was 10 percent and received $107,732 for them. The bonds mature on January 1, 2022 and pay interest on June 30 and December 31. Duncan uses the effective interest method of amortization. The June 30, 2017 entry will include:

Question

Quizplus · Accepted Answer

The effective interest method requires that the bond discount or premium be amortized using the effective interest rate, which is the market interest rate at the time of issuance. The effective interest rate is calculated by dividing the total interest expense over the life of the bond by the bond's carrying value. In this case, the bond was sold at a premium, so the effective interest rate will be less than the stated interest rate of 12%.

To calculate the effective interest rate:
PV = $107,732
FV = $100,000
n = 5 (years)
PMT = $12,000 (annual interest payment)
Solve for i = 5.92%

The first interest payment will be made on June 30, 2017, which is half a year from the date of issuance. The total interest expense for this period will be $12,000 x 6/12 = $6,000. The bond's carrying value at the end of the period will be:
Carrying value = PV of the bond + interest expense - cash payment
Carrying value = $107,732 + $6,000 - $0 = $113,732

To amortize the premium on the bond, the following entry will be recorded on June 30, 2017:
Debit Interest Expense $5,386.60
Credit Premium on Bonds Payable $5,386.60

This journal entry records half of the total interest expense for the period ($6,000/2) and amortizes the bond premium by the same amount. The carrying value of the bond after the journal entry will be $108,345.40 ($113,732 - $5,386.60).

Duncan Industries Sold $100,000 of 12 Percent Bonds on January