Page 603 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

The straight-line method records interest expense at a constant amount; the effective interest rate method
records interest expense at a constant rate. APB Opinion No. 21 states that the straight-line method may be used
only when it does not differ materially from the effective interest rate method. In many cases, the differences are

not material.

An accounting perspective:

Business insight

US government bonds have traditionally offered a fixed rate of interest. In early 1997, the US
Treasury began offering inflation-indexed bonds. The amount of interest on these bonds is tied to
the officially reported rate of inflation. The bonds pay interest every six months, and the interest is
based on the inflation-adjusted value of the principal. These bonds are designed to protect
purchasers against purchasing power loss due to inflation. At that time, there was some concern by

investors that the government had been considering calculating the official rate of inflation
differently than in the past in such a way that it would lower the annual increase as compared to
the then present method of calculation. This change in calculation, if adopted, would lower the
amount of interest earned on these bonds. However, there were some assurances that for this
purpose the official rate of inflation would be calculated the "old way".

The straight-line method The straight-line method of amortization allocates an equal amount of
discount or premium to each month the bonds are outstanding. The issuer calculates the amount by dividing the
discount or premium by the total number of months from the date of issuance to the maturity date. For example, if

it sells USD 100,000 face value bonds for USD 95,233, Carr would charge the USD 4,767 discount to interest
expense at a rate of USD 132.42 per month (equal to USD 4,767/36). Total discount amortization for six months
would be USD 794.52, computed as follows: USD 132.42 X 6. Interest expense for each six-month period then
would be USD 6,794.52, calculated as follows: USD 6,000 + (USD 132.42 X 6). The entry to record the expense on
2010 December 31, would be:
2010
Dec. 31 Bond interest expense (-SE) 6,794.52
Cash (-A) 6,000.00
Discount on bonds payable ($132.42 x 6) 794.52
(+L)
To record interest payment and discount
amortization.
By the maturity date, all of the discount would have been amortized.
To illustrate the straight-line method applied to a premium, recall that earlier Carr sold its USD 100,000 face

value bonds for USD 105,076. Carr would amortize the USD 5,076 premium on these bonds at a rate of USD 141 per
month, equal to USD 5,076/36. The entry for the first period's semiannual interest expense on bonds sold at a
premium is:
2010
Dec. 31 Bond interest expense (-SE) 5,154
Premium on bonds payable ($141 x 6) (-L) 846
Cash (-A) 6,000
To record interest payable and premium

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