On January 1, 2009, an investor paid $291,000 for bonds with a face amount of $300,000. The stated rate of interest is 8% while the current market rate of interest is 10%. Using the effective interest method, how much interest income is recognized by the investor in 2009 (assume annual interest payments and amortization)?

Question

Quizplus · Accepted Answer

Using the effective interest method, the investor will recognize interest income at a rate based on the current market rate of interest. The difference between the market rate and the stated rate is called the premium or discount. In this case, the bonds were purchased at a discount of $9,000 ($300,000 face amount - $291,000 purchase price). The premium or discount is then amortized over the life of the bond using the effective interest method. The effective interest method calculates interest expense by multiplying the carrying value of the bond at the beginning of the period by the effective interest rate. The effective interest rate is calculated as the market rate of interest at the time the bond was issued. Therefore, the interest income recognized by the investor in 2009 is calculated as follows: Carrying value at beginning of year = $291,000; Effective interest rate = 10%; Interest income = Carrying value x Effective interest rate = $29,100. Therefore, the correct answer is B.

On January 1, 2009, an Investor Paid $291,000 for Bonds