Important Equations for the Effective Interest Method of Bond Amortization

Brian Krogol
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Alright, so here I have listed some really important formulas that you're gonna use when you do the effective interest method. Okay, If you if you got these down then you're gonna have no problem with this method. Alright, so the first thing you want to know is the bonds carrying value, the carrying value is the book value of the bond. Okay. So if we are going to release our our balance sheet at any point in time, this is the amount that would show on the balance sheet, it would show the bonds payable account which is the principal amount, right? There's gonna be the principal in the bonds payable account minus whatever discount or plus whatever premium just like we saw when we were when we were studying discounts and premiums. Okay, So we need to know that bond carrying value and we're going to use the table to keep track of it. But that's a very important part of the effective interest method is the bonds carrying value. Okay, so then each of our journal entries is gonna have three parts, We're gonna have the interest expense, has a debit, we're going to have the cash payment as a credit and then we're gonna have the amortization of the discount or the premium and that's going to depend on whether it's a discount or premium, whether it's a debit or credit, but you should start to be familiar with that from our previous previous videos about that. So let's look at each of these these formulas, let's start with the interest expense. So we're taking the bond caring value, right, what it's currently sitting at on our book times the market interest rate and that is going to be our interest expense. That it will always be the debit to interest expense in this method. We're taking the caring value times the market interest rate, the cash interest payment. Well that's gonna be the principal amount of the bonds. So notice we're using both were first using the bond caring value, what it's worth on the books, but then we're for the cash payment. Well, that's always gonna be the principal amount just like we studied before times the stated interest rate. And I want to know if we're doing semiannual payments. Well we're gonna have to divide these by to write the stated interest rate would be half the market interest rate, would be half the amount as well if those were semiannual periods. Okay. And then finally the amortization of the discount or the premium, that's gonna be the plug in the in this method. Okay. Before the plug was the interest expense. When we did the straight line method, Well, the amortization is the plug in this method. Okay, So we calculate our interest expense, we calculate our cash interest payment and then we subtract the two to see what's gonna fill in this entry. So every time we do a journal entry for interest expense. We're always gonna debit interest expense. And we're gonna use that formula above and we're always going to credit cash, right? And this cash could also be interest payable if we're gonna pay it later. But 99% of the time we're gonna see it as cash. You're gonna pay it out as cash. Or it could be interest payable if we're gonna pay the interest at a later date. Okay. And that's gonna be in both journal entries. We're always gonna have a debit to interest expense whether it's a premium or a discount and a credit to cash. Okay. The difference is going to be in the discount or the premium right? The amortization. So when it's a discounted bond, remember that discount? Had a debit balance. So we're gonna use a credit to get rid of that debit balance. So the discount would be credited. Yeah. And it's always gonna be like this when we deal with these journal entries. So we would have some amount for interest expense. Some credit to discount on bonds payable and some credit to cash. The opposite for premiums, right? The premium has a credit balance. So to get rid of it we need debits. So we would have a premium on bonds payable as an additional debit in these transactions and we would have the credit to cash. Okay So now we're gonna take this onto a table and we're gonna see how the interest expense um changes every year. And the the amortization of the discount changes every year. But what's gonna stay constant is the cash payment right? We said we have the principal amount and the stated rate. That's not changing the carrying value that we use in the interest expense formula. That is changing as we go through, Right? So that's gonna affect our interest expense and then it's going to affect our amortization of the discount or premium. Okay? So let's go ahead and apply these formulas to our example that we just calculated the price for. All right, let's do that on the neck.