On January 1, Charlie Corporation issued $3,000,000, 14%, 5-year bonds with interest payable on January 1 and July 1. The bonds sold for $3,216,288. The market rate of interest for these bonds was 12%. Under the effective-interest method, the debit entry to interest expense on July 1 is for (rounded to the nearest dollar):

Question

Quizplus · Accepted Answer

Under the effective-interest method, interest expense is calculated by multiplying the carrying value of the bond at the beginning of the period by the market rate of interest. The carrying value of the bond at the beginning of the first period is $3,216,288 (the price at which the bonds were sold). 
For the first interest payment on July 1, the carrying value of the bond will be the issue price minus the amortized premium. The premium amortization for the first six months is calculated as follows:

Premium amortization = (Effective interest rate - Stated interest rate) x Carrying value 
= (0.12 - 0.14) x $3,216,288 
= -$7,605.60 (rounded to nearest cent)

This negative amount indicates that the premium is being reduced. Therefore, the carrying value of the bond at the beginning of the first interest period will be:

Carrying value = Issue price - Premium amortization 
= $3,216,288 - $7,605.60 
= $3,208,682.40

The interest expense for the first interest period can now be calculated as:

Interest expense = Market rate of interest x Carrying value 
= 0.12 x $3,208,682.40 
= $385,641.89

The interest expense to be recognized on July 1 is half of this amount, or:

Interest expense = $385,641.89 / 2 
= $192,978.

On January 1, Charlie Corporation Issued $3,000,000, 14%, 5-Year Bonds