In this video, we walk through 5 FAR practice questions teaching about calculating the carrying amount of investments measured at amortized cost. 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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## How to Calculate the Carrying Amount of Investments Measured at Amortized Cost

When dealing with **investments measured at amortized cost**, such as bonds or other debt securities, it is crucial to understand how to properly calculate the **carrying amount** over time. This process involves determining how **premiums** or **discounts** are amortized using the **effective interest method**. Below, we’ll walk through the essential concepts, methods, and calculations, complete with examples to ensure clarity.

### Key Concepts

**Amortized Cost**: This refers to the**purchase price**of a bond adjusted over time by amortizing any**premium**or**discount**. It reflects the book value of the bond on the balance sheet.**Effective Interest Method**: This is the preferred method under U.S. GAAP and IFRS for amortizing premiums or discounts. It adjusts the**carrying amount**of the investment by comparing the**interest income**calculated using the**market rate**with the**cash interest payment**derived from the bond’s**stated interest rate**.**Premium vs. Discount**:**Premium**: Occurs when the purchase price of a bond is**greater than its face value**. Amortization**reduces**the carrying amount over time.**Discount**: Occurs when the purchase price of a bond is**less than its face value**. Amortization**increases**the carrying amount over time.

### Step-by-Step Guide to Calculating the Carrying Amount

#### 1. Calculate Interest Income Using the Effective Interest Rate

The **effective interest rate** (market rate at the time of purchase) is used to determine the **interest income**. This rate is applied to the **carrying amount** at the start of the period.

**Example**: A bond with a **face value** of **$100,000** is purchased at a **discount** for **$95,000** with a **stated interest rate of 5%** and a **market rate of 6%**.

**Year 1**:- Beginning carrying amount =
**$95,000** **Interest income**= $95,000 × 0.06 (market rate) =**$5,700**.

- Beginning carrying amount =

#### 2. Calculate the Cash Interest Payment

The **cash interest payment** is based on the **stated interest rate** and the **face value** of the bond.

**Year 1**:**Cash interest payment**= $100,000 (face value) × 0.05 (stated rate) =**$5,000**.

#### 3. Determine the Amortization of the Premium or Discount

The **difference** between the **interest income** and the **cash interest payment** represents the **amortization** amount.

- If the investment is purchased at a
**discount**, the difference is**added**to the carrying amount. - If the investment is purchased at a
**premium**, the difference is**subtracted**from the carrying amount.

**Example (continued)**: Since the bond was purchased at a **discount**:

**Amortization**= $5,700 (interest income) – $5,000 (cash payment) =**$700**.**Adjusted carrying amount**at the end of Year 1 = $95,000 + $700 =**$95,700**.

#### 4. Update the Carrying Amount for Each Period

Repeat the process for each subsequent period, using the **new carrying amount** as the basis for calculating **interest income**.

**Year 2**:- Beginning carrying amount =
**$95,700**. **Interest income**= $95,700 × 0.06 =**$5,742**.**Cash payment**remains**$5,000**.**Amortization**= $5,742 – $5,000 =**$742**.**New carrying amount**= $95,700 + $742 =**$96,442**.

- Beginning carrying amount =

The **carrying amount** continues to **increase** each year as the **discount** is amortized, eventually reaching the **face value** by the bond’s maturity.

### Example with a Bond Purchased at a Premium

Let’s consider a scenario where a bond is purchased at a **premium**:

**Example**: A bond with a **face value** of **$200,000** is purchased for **$210,000** with a **stated interest rate of 4%** and a **market interest rate of 3.5%**.

**Year 1**:- Beginning carrying amount =
**$210,000**. **Interest income**= $210,000 × 0.035 =**$7,350**.**Cash interest payment**= $200,000 × 0.04 =**$8,000**.**Amortization**= $8,000 – $7,350 =**$650**.**Adjusted carrying amount**at the end of Year 1 = $210,000 – $650 =**$209,350**.

- Beginning carrying amount =
**Year 2**:- Beginning carrying amount =
**$209,350**. **Interest income**= $209,350 × 0.035 =**$7,327.25**.**Cash interest payment**=**$8,000**.**Amortization**= $8,000 – $7,327.25 =**$672.75**.**New carrying amount**= $209,350 – $672.75 =**$208,677.25**.

- Beginning carrying amount =

With a **premium**, the **carrying amount** decreases each year as the premium is amortized, moving closer to the **face value** by maturity.

### Journal Entries for Amortized Cost Investments

The journal entries are straightforward once you understand the calculations. Here’s how you record the **amortization**:

**Initial Purchase**:- Debit
**Investment in Bonds**for the purchase price. - Credit
**Cash**for the purchase price. - Example: Purchased for
**$210,000**:- Debit
**Investment in Bonds**$210,000. - Credit
**Cash**$210,000.

- Debit

- Debit
**Annual Amortization (Discount Example)**:- Debit
**Cash**for the interest payment. - Debit
**Investment in Bonds**for the amortization. - Credit
**Interest Income**for the interest calculated. - Example:
- Debit
**Cash**$5,000. - Debit
**Investment in Bonds**$700. - Credit
**Interest Income**$5,700.

- Debit

- Debit
**Annual Amortization (Premium Example)**:- Debit
**Cash**for the interest payment. - Credit
**Investment in Bonds**for the amortization. - Credit
**Interest Income**for the interest calculated. - Example:
- Debit
**Cash**$8,000. - Credit
**Investment in Bonds**$650. - Credit
**Interest Income**$7,350.

- Debit

- Debit

These entries ensure that the **carrying amount** of the investment is accurately adjusted each period to reflect the amortization of the **premium** or **discount**.

### Final Thoughts

Understanding how to **calculate the carrying amount** of **amortized cost investments** is crucial for accurate financial reporting. By using the **effective interest method**, you can ensure that the carrying amount reflects the true economic yield of the investment. Whether dealing with a **premium** or **discount**, the process involves calculating **interest income**, determining **amortization**, and adjusting the **carrying amount** accordingly. With these calculations and journal entries, you can confidently account for debt investments on your balance sheet.