In this video, we walk through 5 FAR practice questions teaching about calculating interest expense for bonds payable. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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**Calculating Interest Expense for Bonds Payable**

When calculating interest expense for bonds payable, it’s essential to understand the different scenarios: bonds issued at par, at a discount, or at a premium. This guide provides a comprehensive overview of each scenario, covering both the effective interest and straight-line amortization methods, as well as bond issuance costs, along with examples to illustrate each case.

### Bonds Issued at Par Value

When bonds are issued at par, the carrying amount of the bond equals its face value, meaning there’s no premium or discount to amortize. Interest expense is simply the product of the bond’s face value and the stated interest rate.

**Example**: Suppose a $1,000 bond is issued at a 5% interest rate with annual payments. The interest expense each period will be: Interest Expense = $1,000 × 5% = $50. This amount remains consistent for each period over the bond’s life, as no amortization is required.

### Bonds Issued at a Discount

When bonds are issued below par value, they are issued at a discount. This typically occurs when the bond’s coupon (stated) interest rate is lower than the market rate at the time of issuance. The difference between the bond’s face value and its issuance price represents the discount, which must be amortized over the bond’s term.

#### Effective Interest Method (Preferred for Discounts)

Under the effective interest method, a growing portion of the discount is added to interest expense each period, resulting in a higher interest expense over time. The interest expense is calculated by multiplying the carrying amount by the market interest rate.

**Example**: Suppose a $1,000 bond with a 4% coupon rate is issued for $950, reflecting a market interest rate of 5%. Interest is paid annually.

**First Payment**:**Carrying Amount**: $950**Interest Expense**: $950 × 5% = $47.50**Cash Paid**: $1,000 × 4% = $40**Discount Amortization**: $47.50 – $40 = $7.50**New Carrying Amount**: $950 + $7.50 = $957.50

**Second Payment**:**Carrying Amount**: $957.50**Interest Expense**: $957.50 × 5% = $47.88**Discount Amortization**: $47.88 – $40 = $7.88**New Carrying Amount**: $957.50 + $7.88 = $965.38

#### Straight-Line Amortization (Allowed Under GAAP)

With the straight-line method, the discount is divided equally over each period, resulting in a fixed discount amortization amount and a constant increase in interest expense each period.

**Example**: If the same bond had a total discount of $50, amortized over 10 periods:

**Discount Amortization per Period**: $50 / 10 = $5**Interest Expense**: Cash Interest Paid + $5

### Bonds Issued at a Premium

Bonds are issued at a premium when they sell above par value, typically because their stated interest rate is higher than the prevailing market rate. The premium (the difference between the issuance price and the face value) must be amortized over the bond’s life.

#### Effective Interest Method (Preferred for Premiums)

Using the effective interest method, interest expense decreases over time because the premium amortization offsets the interest paid. The interest expense each period is calculated by multiplying the carrying amount by the market interest rate.

**Example**: Suppose a $1,000 bond with a 6% coupon rate is issued for $1,050, reflecting a market interest rate of 5%. Interest is paid annually.

**First Payment**:**Carrying Amount**: $1,050**Interest Expense**: $1,050 × 5% = $52.50**Cash Paid**: $1,000 × 6% = $60**Premium Amortization**: $60 – $52.50 = $7.50**New Carrying Amount**: $1,050 – $7.50 = $1,042.50

**Second Payment**:**Carrying Amount**: $1,042.50**Interest Expense**: $1,042.50 × 5% = $52.13**Premium Amortization**: $60 – $52.13 = $7.87**New Carrying Amount**: $1,042.50 – $7.87 = $1,034.63

#### Straight-Line Amortization (Allowed Under GAAP)

With the straight-line method, the premium is amortized equally over the bond’s term, resulting in a fixed reduction in interest expense each period.

**Example**: If the same bond had a total premium of $50, amortized over 10 periods:

**Premium Amortization per Period**: $50 / 10 = $5**Interest Expense**: Cash Interest Paid – $5

### Bond Issuance (Debt Issuance) Costs

Bond issuance costs include expenses such as legal fees, underwriting fees, accounting fees, and printing costs incurred in the process of issuing bonds. These costs are deducted from the bond’s initial carrying amount, effectively reducing it below par. These costs are then amortized over the bond’s life in a similar manner to discount or premium amortization, adding to the total interest expense recognized each period.

**Example**: Suppose a $500,000 bond is issued at par but incurs $10,000 in issuance costs.

**Initial Carrying Amount**: $500,000 – $10,000 = $490,000**Amortization of Issuance Costs**: Over a 10-year term, with annual payments, the issuance costs would be amortized as follows:**Issuance Cost Amortization per Period**: $10,000 / 10 = $1,000**Total Interest Expense per Period**: Cash Interest Paid + Issuance Cost Amortization

### Key Takeaways

**At Par**: Interest expense is straightforward and equals the cash interest paid.**At a Discount**: Interest expense increases each period with the effective interest method, because the discount amortization adds to the interest paid.**At a Premium**: Interest expense decreases each period with the effective interest method, because the premium amortization reduces the interest paid.**Bond Issuance Costs**: These costs reduce the bond’s initial carrying amount and are amortized over the bond’s life, contributing to interest expense each period.