Now, let's talk about bond premium or bond discount amortization. Now, the situation here is as follows. If you issue a bond, not at par, then the amount you collect, if we ignore all the fees, is different from $1,000 for each bond. And therefore, there is a difference. Sometimes it's quite significant and the carrying value of this bond on your account changes over time and then approaches the maturity value at the time of maturity. So, this process is called premium or discount amortization. And to make it clear, I will go ahead with some examples. So the idea is amortization of bond premium discount. Now, so we introduce the idea of carrying value. So this is what shows up on our accounts after. So basically, we placed that at how much money we collect from that at cost and then, we change this carrying value, and we will use an example and for this example again, we will talk about 100 bonds issued. And the parameters are as follows, they're issued at a discount and first of all, we will find what this discount is. So, the face value for 100 bonds will be 100,000. Now, of the maturity period will be 10 years, that is what we sort of postulate. And then, the coupon rate is four percent while the market rate is six percent. So, we can see that C is less than R so this corresponds to a discount. Now, we know how to calculate how much money we will collect in this process. So we know all of the cash flows. The first one will be coupons of the four percent a year here. So each six months, they're are going to be $2,000. So, this is 20 cash flows of $2000 and then the final cash flow of $100,000. Well, 102 with the last coupon, and that should all be discounted at three percent, because this is the annual rate and semi-annual will be three percent. So if we did that, then we can say that the issue price, so, this is present value, will be $85,122. Well, you can check it with the use of your advanced knowledge of corporate finance and PV calculations. And therefore, the amount of discount, this is the difference between the face value and the issue value, which is $14,878. So, this amount should be amortized. How can we do that? Well, we'll study two methods. The first will be a straight line amortization method, the most simplistic but not the most accurate. And the other one, will be much more accurate but a little bit more cumbersome. Alright, so let's keep this in mind and proceed. First of all, with Case 1, straight line amortization. So, in this case, the amortization charge A, the same as for D, when we use depreciation in our analysis of tangible assets. That would be the overall amount of discount 14,878, and then we divide by 20. 20 is the number of periods because again, this is a semi-annual bond. So ten years corresponds to 26-month periods and that is $744. I am rounding things up. So what do we have here? So each six months, we will have interest expense. Let me put it here, interest expense, and interest expense here will be the overall amount that consists of two parts. So first of all, that will be 2,744. So, 2000 is just the coupon payment. Now here, we have cash because this is the amount we pay out in the form of our coupon. But then, we also introduce another account that is discount on bonds payable. So, here we have 744 and this account, then our new carrying value will be, remember it was 85,122. Now, add this and the new carrying value will be equal to 85,866. So, the difference is this amortization of the bond discount. So, this is simple method but the story is what is the actual interest that we have over the first period? So, we take this amount and divide that by 85,122. So, we can say that the first interest, this is about 2.35 percent. Let's say 10th interest expense will be about 2.18 percent. So, we can see that the interest expense, it changes over time. The discount doesn't. So, that shows to you that this is an easy method. But sort of, I'm not saying misleading but not a very clear method because the actual effective interest rates, they are always different here and most often, people use another way. That is called, here on we put a case 2. Effective interest method. Now, what is this method? We say that the interest expense is calculated at the market rate. So, in our example, we have the first carrying value. So, we have $85,122. So, we take this amount and say what is the interest expense at three percent? That will be $2,554. And then, we say that this amount is the discount that is taken to account for this first period. So, we introduce the following accounts. Interest expense, 2,554. Now, cash, this is the coupon paid. This is 2,000, and then the, now, the discount on bonds payable, that will be 554. So, the first one is smaller than it was. Remember it was 744. But the thing is, that now the new carrying value, CV is equal to $85,676. So, what did I do here? This is from here and from here. Now, so far it's not quite clear what with it but see what happens. What happens in 12 months? So, this is for six months. What happens in 12 months? And as always, less one day because we have to introduce another account and then we'll clear things up. So, to find the interest expense, we take this amount and multiply that by three percent. So, the new interest expense will be higher. It will be 2,570. Now, we have interest payable of 2,000. Again, like I said, when this day disappears, then interest payable is paid. So, we'll have cash and interest payable will be nothing here. But now, the discount on bonds here, we add 570. See what happened? The second discount is greater. And now, you can check that the difference is exactly 50 percent. So, this is 554 multiplied by 103. Well, you perceived that and you see that what happens is that over time, discount on bonds payable goes up. And so, does the carrying value that slowly approaches the maturity value. So, I will put some amount just before maturity. So let me put it here, 10 years. Now, discount will be 554 multiplied by 103 to the 19th power, that will be $971 and we will have the following interests here. Interest expense, 2,971. Now, interest payable, 2,000. And then, discount on bonds payable 971. And then, the next day when bonds mature, so this is 10 years less one day. So, this is our final entry. So, we will have interest payable debited by 2,000. Now, bonds payable, because by that time, the bond carrying value, it will actually reach $100,000. And then, we will credit and here will be cash for the final payment of 102. So, the story is that although this process seems to be a little bit more cumbersome, but the effective interest method means that the interest expense for each period is calculated as the carrying value over balance of the bonds. At the beginning of this period, and then, you use the market rate. So, this is sort of the more, let's say natural method. Although, this is kind of cumbersome. If we issued the bond at a premium, then the amount will be higher than the 100,000, and we will have a premium on bonds payable. It will be on the other side and the story will be exactly the same. You have some examples in your assignments. And here, I am wrapping this up and then the next two episodes will say a few words about shareholders equity.
