hi everyone so my name is Zack vines and what I want to go over today is how to actually calculate and do the journal entries for bond amortization when we're using the effective interest method so I want to just really briefly touch on what's going on at a high level before we get into the nitty-gritty of the calculations involved to find those journal entries just kind of the point of why we're doing this and then we'll segue that into the actual calculations themselves so just remember when we have a bond basically what's happening is that a company is wanting to have an immediate inflow of capital so they will sell a bond oftentimes it's a thousand dollar bond to some consumer the consumer will give them the amount of the bond you know either a thousand dollars have it sold at par whatever amount they have to pay for it they give them that amount then over time the company is going to pay a percent called a coupon rate to that consumer who purchased the bond over a period of time and by the end of the date so by the time the bond matures the company gives the full amount the full par value of that bond back to the consumer and so the benefit for the company is that they got to get an immediate inflow of cash so they got to go get that cash then go do stuff with it expand their operations improve their business whatever it is they wanted to do with that immediate inflow the consumer on the other hand is basically giving up however much money the bond cost it in the first place to get those coupon payments over time and then the original amount they paid back at the end so their benefit is that they got to get those coupon payments and earn money like that so overall what's happening is that the bond is gonna be sold at some value so there's a par value associated with the bond that doesn't really change it's just kind of the stated value of the bond but we have a coupon rate which is the percent that the bond pays the consumer who purchased the bond and then we have an effective percentage which is oftentimes based on the market just sort of based on what a normal bond of that type would go for and here's what happens if the coupon percentage so the percentage that the bond pays to the consumer is greater than the percentage that you would expect for someone to be paid of a bond of that type so let's say the coupon rate was 10% and the effective rate was 8% that means that my bond is paying more than what the market would normally pay right now so if that's the case they will sell that bond at a premium meaning the par value might be like a thousand and they're gonna sell it for over $1,000 because if they're paying a percent that's greater than what the market would pay that's a benefit to the consumer who pays for it so they're gonna charge a little bit extra to kind of make it balance out a bit more like that so when it's a premium the selling price is greater than the par value and you're gonna amortize that premium so the difference between your par and what you sold it for down and down and down until it equals your par value or on the other hand if the coupon percent is less than the effective rate that means it's a discount because the rate that the bonds paying isn't quite as much as what the market would normally pay the effective rate and if that's the case then you have to sweeten the deal by making it a little bit cheaper to convince people to buy it because it's not paying as much as what you might get for another bond so that would be at a discount where the selling price would be less than your par value and you're gonna amortize that discount so here's par your discount amount what you paid for it you're gonna amortize up and up and up to your par value so basically what happens is that based on the relationship between your coupon and your effective percent decides whether or not it's a premium or a discount the premium or discount the difference between that selling value and the par value is the amount of the premium or discount and if it's a premium you amortize it down to par if it's a discount you amortize it up to par and so the way we do that one very popular way of doing it is the effective interest method so what we're gonna segue into next is just one big example I'm not going to go through every last bit of it but I'm gonna show you the main calculations you do and how that compiles through it I'll write out the entire example show you how it's worked through and sort of touch on the highlights so we'll do that right now okay so now we're just gonna go through this really big example so from the get-go you're gonna look at this and maybe think this is a huge crazy problem don't worry too much right now it's literally the same steps we're gonna go through it just compiles through the entire amortization schedule so oftentimes you probably won't have to do the entire schedule but I just wanted to give you a comprehensive problem so you can see beginning to end what we do so the problem we have is that we have a 100,000 8% term bond set 8% right there is telling you the coupon payment on the bond what the bond would actually pay the consumer who purchases it and it's sold on 1 1 2019 it's due on 1 1 2024 so it looks like it's about a 5 year period the interest is payable each July 1st and January 1st so we're talking about a semi-annual payment here and said the required effective interest rate is 10% and that the bonds sold for 92 to 78 so just kind of correlating the lesson that we just learned it makes sense to me that first of all this bonds sold for something less than the par value for 92 to 78 instead of the 100,000 because the percent that the bond pays the coupon rate is 8% so if they're only paying 8% but yet the effective rate what we require what would you could expect for a similar bond is 10% then they're probably going to discount it to entice you to purchase that bond so what we're gonna end up doing because this is a discount example is that as we amortize the bond the amortization per period is going to add to your carrying value of your bond and it's gonna be amortized up and up and up until your par value so pretty much the steps that you have to do are gonna be outlined right here what I have on the far left are sort of the first step so that you can solve the first row of information but then those same steps are going to carry through throughout so really the first step is to find out what is your coupon payment or the coupon payment is the amount that the bond actually pays you so in this situation I have it written right there that the coupon payment equals your par value so not necessarily what it sold for unless you sold it at par then it would be the same amount but the actual par of the bond so in this case 100,000 dollars times the coupon for a rate so it's 100,000 times the 8% that it pays times the fraction of the year we're discussing because these are semiannual payments that 8% relates to a yearly consideration so I've wanting to break that down into the payment I get for each six-month period each July 1st in January first I'm gonna multiply that by 6 out of 12 which is just 1/2 and get $4,000 so you can see that that $4,000 is going to go into the coupon payment column and the amortization schedule and it's the same amount every single time because that's the deal that's what you get paid is a certain percent on your par value so we have that entire column filled out right there notice that I'm 1 1 2019 we don't get paid anything in fact nothing really happens except we have some carrying value when the bomb was actually purchased on 1 1 19 because you get paid each July 1st in January 1st not including the first date it was initiated but the bond has to sort of run its course and everything before you start getting those payments there's gonna be nothing in that first row that's really true you know something that I was struggling with when I first started learning this is I would automatically do these calculations plug right in the first row don't do that because the first payment when this stuff really starts happening is going to be the next period which in this case would be on July 1st so that's the coupon payment column now the interest expense is going to be chain it's gonna change every year and here's how you find the interest expense for each year you're gonna take whatever the current carrying value of your bond is whatever it's sitting at so when we first purchase it for 92 to 78 that is the carrying value so you can see that on one 119 my carrying value is 92 to 78 so for this first 4 7 1 19 that's the calculation that I have over there we have the current carrying value which in that case was 92 - 78 I multiply that by my effective interest rate which in this case they tell us is 10% but again because we're dealing with semiannual periods here I have to multiply that by the fraction of the year that it correlates to that's 6 out of 12 and when I do that I end up getting 4,600 $13.90 I just rounded that up to 46 14 when I compiled it right there but you can see that it's going to be different each year because we're applying a consistent rate in a consistent fraction of a year against an ever in this case increasing carrying value because as we amortize the bond the carrying value for a discount is going to get closer and closer higher and higher to your par value where the premium would be the other round way around it gets lower and lower to your par value so the way that we fill out this first column here you know it's nothing and then we get 92 - 78 for the carrying value then on the first date we have the coupon payments initiate and that's going to be the same number throughout the entirety of the bond so I just listed out each date based on you know July 1st and January 1st from 1 119 to 1 124 you can see right there so coupon payments the same the interest expense calculation every time is whatever the previous carrying value was well you know the one that's rolled over to this period so whatever's really one row above it for the carrying value if you're kind of sticking with this chart you're going to multiply that by the effective rate and the fraction of the year and that's going to give you 46 14 then you can see I have that the amount you amortize is the difference between what you recorded for your interest expense and what you recorded for your coupon payment so my discount amortization on seven 119 of 614 that's just the difference between my 46 14 and my 4,000 so keep in mind when it's a discount you amortize up to your par value so that's 614 right there is telling me the amount of the discount I've amortized so if I'm trying to go up to par value add that 614 to your carrying value to get your current carrying value so the 92 892 came from the 614 plus my 92 278 and then it's really just rinse and repeat throughout the rest of this chart we won't go through all of it and we'll go through one or two more so again the coupon payments the same your new interest expense for one 120 is gonna be 46 15 or sorry 46 45 and then when we got 46 45 was just by taking the most recent carrying value that we have which is the 92 892 I multiplied that by 10 percent times the fraction of the year so effectively I'm multiplying it by 5 percent and I got 46 45 the difference between 46 45 and 4000 was 645 so I added 645 to the most recent carrying value of 92 892 to come up with a new carrying value of 93 537 again that 93 537 rolls right over into the next interest expense calculation I'm gonna take that 93 carrying value multiply it by the effective rate times the fraction of the year in that case I got I believe 46 77 sort of losing my train of thought but the 46 77 I believe is where we're at and then the difference between those two gives us the amount we amortize which is the 677 add that 677 to the 93 537 you get 94 214 and you can see you just do that for every single period like this exact same process and you end up amortize the entire bond up to that $100,000 right there so before we wrap things up I want to show you just a couple of journal entries that relate to this and that'll pretty much summarize the entire effective interest method all right so now right here we have the journal entries for at least two of the main transactions two of the main things you would have to worry about when we're dealing with this amortization schedule so what happens first of all we're speaking from the perspectives as if we're the ones selling the bond not paying the bond so all of this is related to our own books where we have our own interest expense or amortize in the discount we are the ones selling the bomb we're the company issuing it so at first what happens is on one 119 we sold that bond for 92 to 78 that was provided information we had to sell it at a discount because our coupon rate was less than the effective rate and so I received cash of 92 to 78 so I debit or increase my cash account and then the difference between what I got when I when I sold the bond the amount of cash that I got that 92 to 78 the difference between that and my bonds payable or the par value is gonna be the amount of my discount and that's the amount that I'm amortized over a period of time so I debit a discount for 77 22 it naturally holds a debit balance so we increase the balance by doing that and then finally the bonds payable again by the end of the term me as the company I'm gonna have to pay back the full par value of the bond to my consumer who purchased the bond from me in the first place at par so pretty much whatever the par value is that's what you put in for the bonds payable and that only goes away when you pay it all back at maturity so we credit bonds payable liability of $100,000 so that's pretty much like the first one 119 then at 7 119 and this is going to be a similar entry for each of these just the numbers are gonna change but the accounts should be the same just depends on which period we're talking about the interest expense is just what we calculated for the interest expense so it was the difference between our coupon payment and what we got when we did our carrying value times the effective rate times the fraction of the year so the difference between the two will the the interest expense itself is that 646 14 right there and the difference between the two was the discount amortization that I talked about so we are reducing the balance in that discount account so when we initially created it it was a debit of 77 22 so now that we're lowering that amount of the discount so we're amortize it away we're going to credit the discount for 614 dollars and finally because we are paying that cash payment out for the coupon payment for those who bought the bonds that's going to be just cash out the door credited decrease it for $4,000 so I hope that gives you a good overview honestly when I was first learning this and I was going through my what 2nd or 3rd accounting class this was very daunting at first because it's a ginormous chart with all these moving parts it seems really complicated from the get-go but you can see that it's basically just a couple of steps that you follow and you do those exact same steps throughout the entire chart so just start by taking your coupon payment which is going to be your coupon rate times your par value par value every time times your fraction of the year that will be the same every year your interest expense is whatever your carrying value is at that moment you multiply that by the effective rate times the fraction of the year and then that's going to give you your interest expense which is going to change every year because their carrying value changes year to year and if it's a discount amortization the difference between the two the coupon payment and the interest expense is added on to the most recent carrying value to give you the current carrying value if it was a premium situation which you know all this was discount if it was premium exact same process except the premium amortization instead of discount amortization would subtract from your carrying value so you get lower and lower down to your par value so I think that about wraps it up thank you so much for watching if you have any questions just put them down in the comments below but thanks for watching and I hope that helped