Financial Accounting and Reporting-CPA Practice Exam

How does the amortization of bond premium affect interest expense calculations?

1. It decreases the recorded interest expense.

2. It has no effect on recorded interest expenses.

3. It increases the reported interest liabilities.

4. It is added to the bond issuance costs.

The correct answer is: It decreases the recorded interest expense.

When a bond is issued at a premium, it means that the market price of the bond is higher than its face value. This situation typically occurs when the coupon rate of the bond is higher than the current market interest rates. The premium represents an amount that investors are willing to pay over the bond's face value because they will receive higher interest payments over the bond's life. The amortization of the bond premium systematically reduces the effective interest expense that the issuer recognizes in their financial statements. As the premium is amortized, it is subtracted from the interest payment made to bondholders, effectively decreasing the interest expense reported on the income statement. This is because the cash interest paid to bondholders remains the same, but the premium amortization shifts some of that cost so that the net interest expense recognized is lower than the cash paid. Thus, as the bond premium is amortized over its life, it results in a lower recorded interest expense in each period. This impact on the financial statements is crucial for understanding how the issuer handles long-term debt and ensures accurate representation of interest obligations in their accounting records.