The Designer Company issued 10-year bonds on January 1, 2011. The 6% bonds have a face value of $800,000 and pay interest every January 1 and July 1. The bonds were sold for $690,960 based on the market interest rate of 8%. Designer uses the effective-interest method to amortize bond discounts and premiums. On July 1, 2011, Designer should record interest expense (round to the nearest dollar) of
A) $27,638
B) $24,000
C) $48,000
D) $55,277

Question

Quizplus · Accepted Answer

The effective-interest method is used to amortize bond discounts and premiums because it results in a constant interest rate over the life of the bond. Under this method, the interest expense is calculated by multiplying the carrying value of the bond by the effective interest rate (market rate at the time of issuance).

Effective Interest Rate = Market Rate at the time of issuance / Number of payments per year
= 8% / 2 = 4%

Interest Expense = Carrying Value of Bond x Effective Interest Rate
= ($800,000 - Discount) x 4%
= ($800,000 - ($690,960 - $800,000)) x 4%
= $800,000 x 4% - ($690,960 - $800,000) x 4%
= $32,000 - $27,638
= $4,362

Therefore, the interest expense recorded on July 1, 2011, should be $27,638 ($32,000 - $4,362).

The Designer Company Issued 10-Year Bonds on January 1, 2011