During the current year, Karaoke Tunes issued $200,000 of bonds for $190,200. If the stated rate of interest was 6.5% and the market rate of interest was 7.1%, how would the company calculate the discount at the time the bonds were issued using the effective interest method?

Question

Quizplus · Accepted Answer

The discount on the bonds represents the additional interest expense that the company will recognize over the life of the bonds. The effective interest method is used to allocate this discount as interest expense over the bond's life in a way that reflects a constant rate of interest.
To calculate the interest expense for the first period using the effective interest method, you would apply the market rate of interest to the carrying amount of the bonds at the beginning of the period. The carrying amount initially is the amount the bonds were issued for, which is $190,200.
Therefore, the correct calculation for the first period's interest expense using the effective interest method is:
a. $190,200 × 7.1%
This calculation reflects the actual market rate of interest at the time the bonds were issued. The result of this calculation will give you the interest expense for the first period. The discount amortized in the first period is the difference between this interest expense and the actual cash interest paid, which is based on the stated rate of interest (6.5%) times the face value of the bonds.
The cash interest paid is calculated as:
d. $200,000 × 6.5%
The difference between the interest expense calculated using the market rate (a) and the cash interest paid (d) is the amount of discount amortized for the period. This amortized amount is added to the carrying value of the bonds, and the new carrying value is used to calculate the interest expense for the next period using the effective interest method. This process continues until the discount is fully amortized over the life of the bonds.

During the Current Year, Karaoke Tunes Issued $200,000 of Bonds