On January 1, 2024, Acme Corp issued $500,000 of 6%, 5-year bonds when the market interest rate was 8%. The bonds pay interest semiannually on June 30 and December 31. Compute the issue price and prepare an amortization schedule for the first two interest periods using the effective interest method.
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Bond Amortization with the Effective Interest Method
On July 1, 2025, Beacon Industries issued $250,000 of 4%, 6-year bonds at a price that yielded an effective rate of 6%. Interest is paid semiannually each January 1 and July 1.
Required: 1. Compute the issue price of the bonds. 2. Prepare an effective-interest amortization schedule for the first three interest payments. 3. Prepare the journal entry to record the first interest payment on January 1, 2026.
Step-by-step walkthrough
Step 1 — Identify the cash flows.
The bond pays $5,000 of cash interest every six months (250,000 × 4% × ½) and returns $250,000 of principal at the end of year 6. With a 6% market yield, the semiannual market rate is 3%.
Step 2 — Compute the issue price.
Discount the 12 semiannual interest payments and the principal repayment at 3% per period:
PV of interest payments = 5,000 × PVA(3%, 12) = 5,000 × 9.9540 = 49,770
PV of principal = 250,000 × PVF(3%, 12) = 250,000 × 0.7014 = 175,350
Issue price ≈ 225,120
The bond sells at a discount of about $24,880 because the stated rate (4%) is below the market rate (6%).
Step 3 — Build the amortization schedule.
Each period:
• Interest expense = beginning carrying value × 3%
• Cash interest paid = 5,000 (constant)
• Discount amortization = interest expense − cash interest
• New carrying value = old carrying value + amortization
Period 1: 225,120 × 3% = 6,754 expense. Amortization = 1,754. New CV = 226,874.
Period 2: 226,874 × 3% = 6,806 expense. Amortization = 1,806. New CV = 228,680.
Period 3: 228,680 × 3% = 6,860 expense. Amortization = 1,860. New CV = 230,540.
Step 4 — Journal entry for the first interest payment (Jan 1, 2026).
Dr Interest Expense 6,754
Cr Discount on Bonds Payable 1,754
Cr Cash 5,000
Key takeaways:
• The discount is amortized over the life of the bond — by maturity, the carrying value equals the $250,000 face.
• Interest expense GROWS each period because the carrying value grows. (For a premium, expense shrinks.)
• Never use the stated rate to compute interest expense — always use the effective (market) rate at issuance.
Common wordings of this problem
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Wilson Inc. sold a $400,000, 5%, 4-year bond issue on January 1, 2025 at a market yield of 7%. Interest is paid semiannually. (a) Determine the cash received from the issuance. (b) Prepare the journal entry for the first interest payment using effective interest amortization.
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A company issues bonds with a face value of $1,000,000 and a stated rate of 5%, when the market rate is 6%. The bonds mature in 10 years and pay interest annually. Compute the issue price and the carrying value of the bonds after the third interest payment under the effective interest method.
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