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Discount Bonds:Interest Expense, Amortization, and Cash

Brian Krogol
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Alright so now let's see how we're gonna do interest expense as we go through these first examples. I'm gonna be using the straight line method of amortization. Okay and when I say amortization, we're gonna be advertising that discount, we had a discount of $3000 and we're gonna advertise it over the life of the bond into interest expense. Okay. I'm gonna show you what that means in a second, but I want to make a note to you. The straight line method is not technically gap, it is not gap but in this class it's very easy and they generally use it because most of the time it's not so different from the gap method. Now if your teacher is really gung ho and really wants to teach you the more difficult method, we're going to have a video on that method as well. Just make sure whether your teacher is gonna focus on straight line, effective interest method or both. Okay. You might even need to know both, but for now let's focus on the straight line method just so you can kind of see how this works. And a lot of the principles between straight line and effective are very similar. Okay, so let's go ahead and dive into this interest expense entry and through interest expense is where that discount will disappear. Okay, so let's go ahead and see how this works on january 1st 2018. Abc company issues 50,000 of 9% bonds, maturing in five years interest is payable, semiannually on january 1st and july 1st the market interest rate was equal to 10%. The bonds were issued at 94. So remember that we had that $3,000, we have a $3,000 in the discount. Right? So now that we're focused on the straight line amortization method, we're gonna advertise it using the straight line method over the amount of interest payments we're gonna make. So if you think about it, this is a five year bond, right? This bond is maturing in five years but we're paying interest twice a year. So there's gonna be 10 total interest payments. So each interest payment, we're gonna advertise some of this discount. Okay So we're gonna take that 3000 discount and divide it by 10. And that means that we're gonna advertise 300 per period advertised. Okay? And we're gonna see what this what I keep saying advertised. What does that mean? Well that means we're taking that 3000 that's sitting in the discount account and we're gonna get rid of it over the life of the bond. We don't want it there anymore because remember at maturity we're gonna pay the full 50,000 not the 47,000 that's currently on our books. So we need to Increase the value of this liability up to the up to 50,000 from the 47,000. It's at right now. We need to keep increasing it over the life of the bond until it's worth 50,000 at maturity. Alright. So let's see how that works in this journal entry, we're going to be advertising 300 per period of our discount. But we're also going to be paying cash right just like before we had our cash interest payments where we had 50,000 in principle times the stated rate, right? Were the cash interest that we pay is based on the stated rate. It doesn't matter the market rate. We're saying, hey we're paying 9%. Well we're gonna pay 9%. So the 50,000 in principle times the 9%. That's the legal amount of interest that we owe to these people. And that's gonna be a yearly amount. Just like we discussed with face value bonds. So we have to divide it by two because we're dealing with this semiannual interest. So the 9% is an annual interest amount. So we divided by two because we pay interest twice per year. So each interest payment is gonna be half of the annual amount. So 50,000 times point oh nine divided by two, forgot what we had that in the last video times point oh nine divided by two Comes out to $2,250 and this is the cash interest that will be paid. Okay now I want to make a note between this and the face value bonds in the face value bonds. The cash interest was our interest expense. That's not the case anymore. Unfortunately when we've got a discount or a premium, our interest expense is going to be different from the actual cash interest that we paid. And that's because we're advertising the discount or the premium. So let's go ahead and see how we're gonna advertise this discount. We know that we're gonna have a credit to cash on July one when we have the six months of interest we're paying well we're gonna pay off 2250 in cash. Right? So that's gonna be one of our credits. But notice we also had this discount and the discount had a debit balance right Because we had a credit to bonds payable And then the discount which was lowering the value of bonds payable down to 47,000 we had that $3,000 value. Well we want to get rid of that discount and since it had a debit balance before we get rid of it with credits. And what that's going to be doing is going to be increasing the value of the bond as we keep crediting to these liabilities. Okay so let's go ahead and see what we do here. We're going to credit discount on bonds payable and I'm gonna put discount on BP for bonds payable. So we're gonna be crediting the discount account because remember up here when we first issued the bonds it had a debit balance right. We issued them with a debit balance in the previous video. And now we're gonna be crediting it to get rid of that debit balance. So we have that debit balance of 3000 and we're gonna be advertising it over the 10 interest payments five years twice per year. We're gonna be advertising it 300 per period. So we're gonna have a credit of 300. So what does that do to our discount account? Our discount is now 3000 debit. Right well let me do it as a as a T. Account. Right? We had the T. Account for discount on on bonds payable and it had a debit balance of 3000 in the first entry. Well right now we're crediting it for 300. So that's gonna bring its value down to 2700 as a debit balance. Right? So now the debit balance is only 2700 rather than 3000. Okay So what does that mean the bonds we still have bonds payable? So when we show our our balance sheet we're still gonna show bonds payable of 50,000 But now it's gonna be less discount instead of 3000, the discount is only gonna be 2700. So our face our our bond instead of being 47,000 is now 47,300. So our liability increases right? Because of this credit to discount on bonds payable and it's gonna keep increasing over the life of the bond. Okay so that's what that credit to bonds payable? Does credit to discount on bonds payable? Does it's increasing that carrying value on the balance sheet of our bonds payable. Okay. So the last part of this entry. Well, guess what? This is an interest expense entry. Right? We're paying interest. So we're gonna have interest expense here and that's going to be our debit. So our debit to interest expense. Well, it's going to be the sum of these two. We paid the cash and we're gonna advertise some of the discount of 300. So this comes out to 2550. All right. And this is about as tricky as this class gets. Okay. So if you understood this, wow, I'm really proud of you for getting this on the first try. But I don't expect you to really understand everything we went through. Okay. So we're gonna keep going through this example and then you're gonna see it with premiums on bonds payable. And I hope once you see both of them side by side this will start to make a lot more sense. And then I want you guys to keep hammering this in because this is about as tough as this course is gonna get. Okay, so this is our journal entry right here. We're going to debit interest expense 2550 credit. The discount on bonds payable to lower its value a little bit And we're going to credit cash for the actual cash that we paid out. Okay. So what happened in this entry? Well, our cash decreased by 2250. But what else happened? We had our discount on bonds payable. Remember it had a a debit balance and we credited it. So it has less of a debit balance. So it increased our liabilities right? Just like we saw here before we had a net balance of 47,000, right before this interest expense. Because the discount was sitting at 3000. Well now there's less discount. So our liabilities have increased from 47,000 to 47,300. So that's an increase to our liabilities of 300 and then our interest expense. Well, that's a decrease to equity, right? 2550 decrease to equity. So the decreased equity 2550. The increased the liabilities of 300 that equals the decrease to assets of 2250. This is getting a little bit complicated right now let's keep it going in the next video