Final answer:
The amortization of an available-for-sale debt security purchased at a discount involves recording an increase in the bond's book value over time. The journal entry includes debiting interest revenue and crediting the discount on investment account, which adjusts the bond's carrying value on the balance sheet.
Step-by-step explanation:
When an available-for-sale debt security is purchased at a discount, the process of accounting for the increment of the security's book value towards its face value over time is known as amortization. The journal entry to record this amortization will typically include debiting the interest revenue and crediting the discount on investment account. The discount on investment acts as a contra account to the bond payable, reducing its carrying amount on the balance sheet as the discount is amortized into income.
This amortization of the discount increases the investment's carrying value on the balance sheet and recognizes interest income in the income statement. As the bond approaches maturity, the book value of the bond will reach its face value. The effective interest rate method is often used for the amortization of the discount, where the market interest rate at the time of purchase is applied to the carrying amount of the security to determine the amortization for the period.
When discussing available-for-sale securities, recognizing that choosing the appropriate interest rate for discounting is a complex decision is essential. This rate must reflect expectations of future benefits, including both potential capital gains and dividend payments, to accurately represent the present discounted value of the benefits to be received over the term of the bond.