Can anyone explain this? Effective interest rate Q:
QUESTION:
On July 1, 2004, York Co. purchased, as a held-to-maturity investment, $1,000,000 of Park, Inc.'s 8% bonds for $946,000, including accrued interest of $40,000.
The bonds were purchased to yield 10% interest. The bonds mature on January 1, 2011 and pay interest annually on January 1. York uses the effective interest method of amortization.
In its December 31, 2004 Balance Sheet, what amount should York report as investment in bonds?
ANSWER:
$911,300
Initial investment cost: $946,000-$40,000 = $906,000
Interest revenue for 2004: $906,000(.10)(1/2 year) = $45,300
Less cash interest for 6 months: $1,000,000(.08)(1/2) = (40,000)
Equals amortization of discount (increases investment)
5,300
Investment in bonds balance at the end of 2004
$911,300
The initial investment cost or balance excludes accrued interest. The bonds were purchased at the halfway point in the interest period. York must pay for 1/2 a year's interest, and will receive a full year's interest on January 1, 2005. The interest revenue for the year is based on the effective yield of 10%. The difference between interest revenue and the cash interest earned for the second half of 2004 is the growth in the value of the bond over time.
The book value of the bond investment at maturity will be $1,000,000. Thus, the discount amortization increases the investment carrying value each year until it reaches $1,000,000.
MY QUESTION:
Why is the interest revenue calculated on the initial cost and not the carry amount ($946,000)? I thought when you use the effective interest method, you are taking the interest on the carrying amount to date, including all the interest up to that point?
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