Effective Interest Method of Discount/Premium Amortization
Under the effective interest method, amortization of discount/premium and/or transaction cost on a financial asset/liability equals the difference between interest income/expense on the asset/liability at the effective interest rate and interest receipts/payments at the stated interest rate.
In case of a financial asset, the effective interest rate is the rate at which the gross carrying amount plus the initial transaction costs equal the future cash inflows.
Gross carrying amount of financial asset = Face value ± Premium/Discount + Transaction costs
In case of a financial liability, the effective interest rate is the rate at which the future cash outflows equal the bond face value plus/minus premium/discount minus transaction costs.
Amortized cost of financial liability = Face value ± Premium/Discount - Transaction costs
In other words, the effective interest rate is the internal rate of return of the financial asset or liability.
The effective interest method is applied as follows:
- Fair value of the asset/liability and associated transaction costs are determined.
- Effective interest rate is determined.
- The periodic effective interest rate is applied to the opening carrying amount of asset/liability to determine the interest income/expense for the period.
- The stated interest rate is applied to the face value of the asset/liability to determine interest receipt/payment.
- The amortization of discount/premium and transaction cost are determined as the difference between interest income/expense and interest receipt/payment.
- Period-end carrying amount of a financial asset/liability is determined by adding/subtracting discount/premium amortized during a period to opening carrying amount.
Company K issued 5-year 8%-annual coupon bonds with a face value of $100,000 for $92,420. The effective interest rate can be determined as the rate at which the bond’s future cash flows, i.e. the 5 coupon payments of $8,000 in each year, and the final maturity value of $100,000 equal the initial amount of $92,420. This works out to 10% per annum.
Under the effective interest method, the first year interest expense is $9,242, determined as the product of the effective interest rate of 10% and the opening carrying amount of the bond of $92,420. Interest paid or payable equals $8,000, determined as the product of the stated interest rate of 8% and the face value of $100,000. The amortization of bond discount for the first year is simply the difference between these two figures and it equals $1,242.
Company K would record the amortization and interest expense using the following journal entry:
At the end of Year 1, the carrying amount would be $93,662 ($92,420 plus the amortized bond discount of $1,242). Hence, in Year 2, interest expense would be $9,366 ($93,662 multiplied by 10%). As the stated interest rate of 8% is the same for each year, interest paid in Year 2 is $8,000. Bond amortization in Year 2 is $1,366 ($9,366 minus $8,000).
The company would post the following journal entry:
We can create a bond amortization schedule to see expected bond amortized cost in future periods. You can see that under the effective interest method, the amount of bond discount amortized increases over the life of the bond. This is in contrast with the straight-line amortization in which amortization is allocated equally to all periods.
Accounting standards mostly allow only the effective interest method for amortization of discount/premium and transaction costs.