FAR CPA Practice Questions: Carrying Amount of Investments Measured at Amortized Cost

Investments Measured at Amortized Cost

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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.

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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

  1. 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.
  2. 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.
  3. 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.

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.

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.
  • 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.

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.
  • 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.
  • 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.

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.

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