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Principles of Accounting, Volume 1: Financial Accounting

13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

Principles of Accounting, Volume 1: Financial Accounting13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation.

Pricing of Long-Term Notes Payable

When a consumer borrows money, she can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. In these timed payments, part of what she pays is interest. The amount borrowed that is still due is often called the principal. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan. A fully amortized loan is fully paid by the end of the maturity period.

In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. She will repay the loan with five equal payments at the end of the year for the next five years. The bank’s required interest rate is an annual rate of 12%.

Interest rates are typically quoted in annual terms. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan.

After each payment in a fully amortizing loan, the principal is reduced, which means that since the five payment amounts are equal, the portion allocated to interest is reduced each year, and the amount allocated to principal reduction increases an equal amount.

We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan. An amortization table calculates the allocation of interest and principal for each payment and is used by accountants to make journal entries. These journal entrieswill be discussed later in this chapter.

The first step in preparing an amortization table is to determine the annual loan payment. The $10,000 loan amount is the value today and, in financial terms, is called the present value (PV). Since repayment will be in a series of five equal payments, it is an annuity. Look up the PV from an annuity table for 5 periods and 12% interest. The factor is 3.605. Dividing the principal, $10,000, by the factor 3.605 gives us $2,773.93, which is the amount of each yearly payment. For the rest of the chapter, we will provide the necessary data, such as bond prices and payment amounts; you will not need to use the present value tables.

When the first payment is made, part of it is interest and part is principal. To determine the amount of the payment that is interest, multiply the principal by the interest rate ($10,000 × 0.12), which gives us $1,200. This is the amount of interest charged that year. The payment itself ($2,773.93) is larger than the interest owed for that period of time, so the remainder of the payment is applied against the principal.

Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest. Assume that the final payment will be $2,774.99 in order to eliminate the potential rounding error of $1.06.

Year, Beginning Balance, Payment, Interest, To Principle, Ending Balance (respectively): 1, $10,000.00 2,773.93, 1,200.00, 1573.93, 8,426.07; 2, 8,426.07, 2,773.93, 1,011.13, 1,762.80, 6,663.27; 3, 6,663.27, 2,773/93, 799.59, 1,974.34, 4,688.93; 4, 4,688.93, 2,773.93, 562.67, 2,221.26, 2,477.67; 5, 2,477.67, 2,477.67, 297.32, 2,476.61, 0. There is a circle pointing to the Payment column indicating that it is an annual payment. There is a circle pointing to the Interest column indicating that it is Interest Rate times Beginning Balance. There is a circle pointing to the Principle column indicating that it is Payment minus Interest. There is a circle pointing to the Ending Balance column indicating that it is Beginning Balance minus To Principle. There is a circle pointing to the last 1.06 indicating that it is a rounding difference.
Figure 13.7 Amortization Table. An amortization table shows how payments are applied to interest in principal for the life of the loan. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Your Turn

Creating Your Own Amortization Table

You want to borrow $100,000 for five years when the interest rate is 5%. You will make yearly payments of $23,097.48 for 5 years. Fill in the blanks in the amortization table below. Assume that the loan was created on January 1, 2018 and totally repaid by December 31, 2022, after five equal, annual payments.

Year, Beginning Balance, Cash Payment, Interest Expense, To Principal, Ending Balance (respectively): 1, $100,000.00, 23,097.48, ?, ?, ?; 2, ? , 23,097.48, ?, ?, ?; 3, ? , 23,097.48, ?, ?, ?; 4, ? , 23,097.48 , ?, ?, ?; 5, ? , 23,097.48 , ?, ?, ?.

Solution

Multiply the $100,000 by the 5% interest rate and $5,000 is the amount of interest you owe for year 1. Subtract the interest from the payment of $23,097.48 to find $18,097.48 is applied toward the principal ($100,000), leaving $81,902.52 as the ending balance. In year 2, $81,902.52 is charged 5% interest ($4,095.13), but the rest of the 23,097.48 payment goes toward the loan balance. Follow the same process for years 3 through 5.

Date, Beginning Balance, Cash Payment, 5 percent Interest Expense, To Principal, Ending Balance (respectively): December 31, 2018, $100,000.00, 23,097.48, 5,000.00, 18,097.48, 81,902.52; December 31, 2019, 81,902.52, 23,097.48, 4,095.13, 19,002.35, 62,900.17; December 31, 2020, 62,900.17, 23,097.48, 3,145.01, 19,952.47, 42,947.69; December 31, 2021, 42,947.69, 23,097.48 , 2,147.38, 20,950.10, 21,997.60; December 31, 2022, 21,997.60, 23,097.48 , 1,099.88, 21,997.60, 0.00. Total Cash Payment: $115,487.40; Total 5 percent Interest Expense: $15,487.40; Total To Principal: $100,000.00.

Bonds Payable

As you’ve learned, each time a company issues an interest payment to bondholders, amortization of the discount or premium, if one exists, impacts the amount of interest expense that is recorded. Amortization of the discounts increases the amount of interest expense and premiums reduce the amount of interest expense. There are two methods used to amortize bond discounts or premiums: the effective-interest method and the straight-line method.

Our calculations have used what is known as the effective-interest method, a method that calculates interest expense based on the carrying value of the bond and the market interest rate. Generally accepted accounting principles (GAAP) require the use of the effective-interest method unless there is no significant difference between the effective-interest method and the straight-line method, a method that allocates the same amount of the bond discount or premium for each interest payment. The effective interest amortization method is more accurate than the straight-line method. International Financial Reporting Standards (IFRS) require the use of the effective-interest method, with no exceptions.

The straight-line method doesn’t base its calculation of amortization for a period base on a changing carrying value like the effective-interest method does; instead, it allocates the same amount of premium or discount amortation for each of the bond’s payment periods.

For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. The net effect of creating the $40,000 premium and writing off $10,000 of it gives the company an interest expense of $40,000 instead of $50,000, since the $50,000 expense is reduced by the $10,000 premium write down at the end of the year.

Three journal entries are dated January 1, 2019. The first shows a debit to cash for 540,000, a credit to bonds payable for 500,000, and a credit to premium on bonds payable for 40,000. The second shows a debit to interest expense for 50,000 and a credit to cash for 50,000. The third shows a credit to premium on bonds payable for 10,000 and a credit to interest expense for 10,000.
Figure 13.8 Premium Amortization Using the Straight-Line Method. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Issued When Market Rate Equals Contract Rate

Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. The bond was issued at par, meaning it sold for $100,000. There was no premium or discount to amortize, so there is no application of the effective-interest method in this example.

Issued at a Premium

The same company also issued a 5-year, $100,000 bond with a stated rate of 5% when the market rate was 4%. This bond was issued at a premium, for $104,460. The amount of the premium is $4,460, which will be amortized over the life of the bond using the effective-interest method. This method of amortizing the interest expense associated with a bond is similar to the amortization of the note payable described earlier, in which the principal was separated from the interest payments using the interest rate times the principal.

Begin by assuming the company issued all the bonds on January 1 of year 1 and the first interest payment will be made on December 31 of year 1. The amortization table begins on January 1, year 1, with the carrying value of the bond: the face value of the bond plus the bond premium.

On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000). The cash interest payment is the amount of interest the company must pay the bondholder. The company promised 5% when the market rate was 4% so it received more money. But the company is only paying interest on $100,000—not on the full amount received. The difference in the sale price was a result of the difference in the interest rates so both rates are used to compute the true interest expense.

Year, Cash Interest Payment, Interest on Carrying Value, Amortization of Premium, Carrying Value (respectively): January 1 Year 1, -, -, 0, 104,460 ; December 31 Year 1, 5,000, 4,178, 822, 103,638. There is a circle pointing to the Cash Interest Payment column indicating that it is Stated rate times Principal. There is a circle pointing to the Interest on Carrying Value column indicating that it is Market Rate times Carrying Value. There is a circle pointing to the Amortization of Premium column indicating that it is Cash Interest Rate minus Interest on Carrying Value. There is a circle pointing to the Carrying Value column indicating that it is Prior Carrying Value minu Amortization of Premium. Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 104,460 on the debit side, 5,000 on the credit side and a debit balance of 99,460 equals T account for Bonds Payable showing 100,000 on the credit side plus the Premium on Bonds Payable T account showing 4,460 on the credit side, 822 on the debit side and a 3,638 balance minus the Interest Expense T account with 5,000 on the debit side and 822 on the credit side with a 4,178 debit balance.

The interest on the carrying value is the market rate of interest times the carrying value: 0.04 × $104,460 = $4,178. If the company had issued the bonds with a stated rate of 4%, and received $104,460, it would be paying $4,178 in interest. The difference between the cash interest payment and the interest on the carrying value is the amount to be amortized the first year. The complete amortization table for the bond is shown in Figure 13.9. The table is necessary to provide the calculations needed for the adjusting journal entries.

Year, Cash Interest Payment, Interest on Carrying Value, Amortization of Premium, Carrying Value (respectively): January 1 Year 1,  -, -, -, 104,460; December 31 Year 1, 5,000, 4,178, 822, 103,638; December 31 Year 2, 5,000, 4,146, 854, 102,784; December 31 Year 3, 5,000, 4,111, 889, 101,895; December 31 Year 4, 5,000, 4,076, 924, 100,971; December 31 Year 5, 5,000, 4,029, 971, 100,000. There is a circle pointing to the Cash Interest Payment column indicating that it is Stated Rate times Principal. There is a circle pointing to the Interest on Carrying Value column indicating that it is Market Rate times Prior Carrying Value. There is a circle pointing to the Amortization of Premium column, indicating that it is Difference between Cash Interest Payment and Interest on Carrying Value. There is a circle pointing to the Carrying Value column indicating that it is Prior Carrying Value minus Amortization of Premium.
Figure 13.9 Bond Amortization Table. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Issued at a Discount

The company also issued $100,000 of 5% bonds when the market rate was 7%. It received $91,800 cash and recorded a Discount on Bonds Payable of $8,200. This amount will need to be amortized over the 5-year life of the bonds. Using the same format for an amortization table, but having received $91,800, interest payments are being made on $100,000.

Year, Cash Interest Payment, Interest on Carrying Value, Amortization of Discount, Carrying Value (respectively): January 1 Year 1, -, -, -, 91,800 ; December 31 Year 1, 5,000, 6,426, 1,426, 93,226.

The cash interest payment is still the stated rate times the principal. The interest on carrying value is still the market rate times the carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of discount amount is added to the carrying value.

Year, Cash Interest Payment, Interest on Carrying Value, Amortization of Premium, Carrying Value (respectively): January 1 Year 1, -, -, -, 91,800; December 31 Year 1, 5,000, 6,426, 1,426, 93,226; December 31 Year 2, 5,000, 6,526, 1,526, 94,752; December 31 Year 3, 5,000, 6,633, 1,633, 96,384; December 31 Year 4, 5,000, 6,747, 1,747, 98,131; December 31 Year 5, 5,000, 6,869, 1,869, 100,000. There is a circle pointing to the Cash Interest Payment column indicating that it is Stated Rate times Principal. There is a circle pointing to the Interest on Carrying Value column indicating that it is Market Rate times Prior Carrying Value. There is a circle pointing to the Amortization of Discount column indicating that it is Difference between Cash Interest Payment and Interest on Carrying Value. There is a circle pointing to the Carrying Value column indicating that it is Prior Carrying Value plus Amortization of Discount.

Figure 13.10 illustrates the relationship between rates whenever a premium or discount is created at bond issuance.

Large arrow pointing up with the words “Stated Rate > Market Rate, Bond is issued at a premium.” Large arrow pointing down with the words “Stated Rate < Market Rate, Bond is issued at a discount.”
Figure 13.10 Stated Rate and Market Rate. When the stated rate is higher than the market rate, the bond is issued at a premium. When the stated rate is lower than the market rate, the bond is issued at a discount. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Concepts In Practice

Bond Ratings

Investors intending to purchase corporate bonds may find it overwhelming to decide which company would be the best to invest in. Investors are concerned with two primary factors: the return on the investment (meaning, the periodic interest payments) and the return of the investment (meaning, payment of the face value on the maturity date). While there are risks with any investment, attempting to maximize the return on the investment and maximizing the likelihood receiving the return of the investment would take a significant amount of time for the investor. To become informed and make a wise investment, the investor would have to spend many hours analyzing the financial statements of potential companies to invest in.

One resource investors find useful when screening investment opportunities is through the use of rating agencies. Rating agencies specialize in analyzing financial and other company information in order to assess and rate a company’s riskiness as an investment. A particularly useful website is Investopedia which highlights the rating system for three large rating agencies—Moody’s, Standard & Poor’s, and Fitch Ratings. The rating systems, shown below, are somewhat similar to academic grading scales, with rankings ranging from A (highest quality) to D (lowest quality):

Rating Agencies8
Credit Risk Moody’s Standard & Poor’s Fitch Ratings
Investment Grade
Highest Quality Aaa AAA AAA
High Quality Aa1, Aa2, Aa3 AA+, AA, AA– AA+, AA, A–
Upper Medium A1, A2, A3 A+, A, A– A+, A, A–
Medium Baa1, Baa2, Baa3 BBB+, BBB, BBB– BBB+, BBB, BBB–
Not Investment Grade Ba1 BB+ BB+
Speculative Medium Ba2, Ba3 BB, BB– BB, BB–
Speculative Lower Grade B1, B2, B3 B+, B, B– B+, B, B–
Speculative Risky Caa1 CCC+ CCC
Speculative Poor Standing Caa2, Caa3 CCC, CCC–
No Payments / Bankruptcy Ca / C
In Default D DDD, DD, D
Table 13.1

Footnotes

  • 8 Michael Schmidt. “When to Trust Bond Rating Agencies.” Investopedia. September 29, 2018.
    https://www.investopedia.com/articles/bonds/09/bond-rating-agencies.asp
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