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13 -- Effective-Interest Method - YouTube
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I'm Larry Walter this is principles of
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accounting dot-com chapter 13 in this
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module we will continue our discussion
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of account
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for bonds payable now however we are
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going to shift from the straight line to
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the effective interest amortization
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methods and so let's first recall under
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the effective interest amortization
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method interest expense will be
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recognized as a constant percentage of a
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bonds carrying value rather than as an
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equal amount each period as was the case
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under the straight-line approach
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interest expense is calculated as the
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bonds carrying value that is the face
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amount of the bond or par amount plus in
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the unamortized premium or minus any
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unamortized discount the net of those
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amounts the carrying value times the
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effective interest rate that was
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implicit in the bond at the time it was
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issued and we'll see examples of this in
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a moment
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the amount of amortization is the
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difference between the cash paid for
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interest during a period and the amount
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that's calculated under the formulation
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of carrying amount times effective
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interest rate to illustrate recall from
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our previous illustrations that we had a
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bond that was priced to yield 6% and
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this was an 8% bond and it was priced at
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108 thousand five hundred and thirty
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dollars in a previous module as well as
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the textbook this calculation is
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illustrated so for now let's assume it's
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just a correct number one hundred eight
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thousand five thirty the effective
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interest rate for the very first six
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month period of holding that bond will
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calculate to be three thousand two
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hundred fifty five dollars and ninety
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cents that's the one hundred and eight
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thousand five thirty times the 6%
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effective rate for six months or times
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six twelfths of a year so we take that
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total thirty two hundred and fifty five
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dollars and ninety cents of interest and
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compare that to the four thousand that
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is being paid that is it's an eight
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percent stated rate bond eight percent
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times the hundred thousand times half of
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a year would give us four thousand as
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the cash that's paid the difference
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between that four thousand cash paid on
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the one hand and the calculated amount
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of interest on the other hand gives us
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the premium amortization of seven
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hundred and forty four dollars now that
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premium amortization serves to reduce
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the net book value of the bond that is
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after recording the m-word as I
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the carrying value will be reduced to
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one hundred and seven thousand 785 the
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beginning amount minus the premium
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amortization over time we started with
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the eight thousand five hundred and
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thirty dollars of premium it's going to
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be completely amortized over the life of
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the bomb through this effective interest
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method that new balance that's
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established for the next period that is
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the hundred and seven thousand seven
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eighty five that is the benchmark upon
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which interest will be calculated during
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the next period and here is an
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amortization table to illustrate this so
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we start out with a hundred and eight
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thousand five hundred and thirty dollars
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we multiply that times the effective
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interest rate and reflect that it's only
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for six months of the year and we
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calculate interest expense at thirty to
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fifty five compared to the four thousand
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dollar payment gives us a difference of
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seven forty four or the premium
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amortization that reduces the premium
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and leaves the new carrying value the
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bond payable plus the unamortized
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premium at one hundred and seven
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thousand seven eighty five ninety that
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becomes the balance for the next periods
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calculation and we would calculate
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interest on that and it would come to
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three thousand two hundred and thirty
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three dollars this process would
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continue as you can see in the
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amortization table period after period
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notice that in the very last period the
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bonds carrying value of one hundred
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thousand nine hundred and seventy times
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the 6% for half a year would give us
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interest expense of three thousand
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twenty-nine compared to the four
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thousand dollars paid would give rise to
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nine hundred and seventy dollars of
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premium amortization enough to exactly
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reduce the bond to its one hundred
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thousand face amount the amount that's
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then do at the maturity date on December
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31 of year five so it's a perfect
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process if the numbers are carried out
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exactly correctly it's a perfect process
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so that over the life of the bond the
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premium will be completely amortized and
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each period the interest expense is
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reflected as six percent of the bonds
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carrying value for that period of time
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let's look at a journal entry the
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initial journal entry to record the bond
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issuance as well as the subsequent entry
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to record repayment of the bond at
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maturity would be identical to those
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illustrated under the straight-line
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method we won't repeat those here
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however would record a little bit
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different amount of periodic expense so
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for example for June thirtieth year
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three example
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diverting interest expense 3000 162 you
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can find that amount in the amortization
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table which is reproduced in the
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textbook
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we're debiting premium on bonds payable
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for the difference between that and the
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credit cash four thousand dollar payment
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we can repeat this process looking at a
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discount we had another scenario where
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the bonds were priced to yield 10
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percent and that came out at 92 thousand
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to 78 now the effective interest rate
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for the first six months is ninety two
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seventy eight times ten percent for half
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a year that is four thousand six hundred
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and thirteen dollars of that amount
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four thousand is paid in cash that's
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still our eight percent stated rate
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calculation the difference between the
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expense and the cash payment is discount
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amortization of six hundred and thirteen
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dollars and ninety cents and the
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discount amortization increases the net
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book value the debt after the first
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period of 92 eight ninety one that is
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the beginning balance of 92 to seventy
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eight plus six hundred and thirteen
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dollars that new balance that is the
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92008 92009 t 2002 seventy eight we
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calculate interest thereon at forty six
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thirteen compared to the four thousand
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dollar cash payment gives us the
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discount amortization of six hundred
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thirteen dollars and ninety cents and
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that reduces the balance to 92008 92009
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the process repeats period after period
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the initial journal entry to record the
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issuance of the bonds and the final
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journal entry to record repayment at
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maturity would be identical to those
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that were illustrated when we looked at
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this problem under the straight-line
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method in a previous module however each
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journal entry would record a little bit
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different amount of periodic expense now
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in this case in the journal entry for
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june thirtieth of year three we're
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debiting interest expense four thousand
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seven hundred forty six dollars that's
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the calculated amount for our
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amortization table bear in mind only
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four thousand of that is paid in cash
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the credit to cash the difference is our
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discount amortization seven forty six
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twenty now we're crediting the discount
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account as we a more
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remember it has a debit balance it's a
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contra account to the debt account so
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we're crediting it to reflect the
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decline in that discount account over
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time and that will take the discount
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account balance to exactly zero at
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maturity
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