Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.
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At the maturity, carrying a value of a bond will reach to the par value of the bond and is paid to the bondholder. Suppose 5-year $ 100,000 bond is issued with a 9% semiannual coupon in a 10% market $ 96,149 in Jan’17 with interest payout in June and January. Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000. The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. However, the effective interest method requires more work because it needs to be recalculated for every individual interest-earning period. Therefore, it is commonly only used when a bond is purchased at a significant premium or discount or when the bond’s book value increases or decreases significantly during the life of the bond.
Due to the straight-line method’s conceptual problem, the FinancialAccountingStandardsBoard requires the use of the effective interest method unless there are no material differences between the two. Over the life of the bond, this percentage interest rate continues to decrease until 2 January 2025, when it reaches 6.7% (or $6,702 / $99,294). It’s the number that the lender typically advertises as the interest rate. By contrast, in the EIR, the periodic rate is annualized using compounding. It is the standard in the European Union and many other countries around the world. Any information obtained from Users of this Website at the time of any communication with us (the “Company”) or otherwise is stored by the Company. Any information obtained from Users of this Website at the time of any communication with us (the “Company”) or otherwise is stored by the Company.
The effective interest rate calculation does not take into account one-time fees like loan origination fees. These fees are considered, however, in the calculation of the annual percentage rate.
As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan. Under the effective interest method, a constant interest rate—equal to the market rate at the time of issue—is used to calculate the periodic interest expense. The critical observation to make is that the straight line method is a much more simple calculation. Straight line amortization of premiums or discounts results in the same amount of interest expense, amortization, and cash interest in every single year until the bond is repaid.
In this case, the effective rate would be a 7% ROI on the difference between the investment and the maturity value, plus the 2% coupon rate, for a combined yield of 9%. Under US GAAP, the effective interest rate is computed on the basis of the contractual cash flows over the contractual term. The effective interest method is preferable to the straight-line method of charging off premiums and discounts on financial instruments, because the effective method is considerably more accurate on a period-to-period basis. However, it is also more difficult to compute than the straight-line method, since the effective method must be recalculated every month, while the straight-line method charges off the same amount in every month. Thus, in cases where the amount of the discount or premium is immaterial, it is acceptable to instead use the straight-line method. By the end of the amortization period, the amounts amortized under the effective interest and straight-line methods will be the same.
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The actual interest income is 4% multiplied by the $104,100 carrying amount, or $4,164, and the premium amortization for year one is $4,500 less $4,164, which equals $336. The amortization of $336 is posted to bond expense, and the amount also reduces the carrying amount of the bond. Rather than assigning an equal amount of amortization per period, the effective-interest method calculates different amounts to transfer to interest expense each period.
The Effective Interest Method corrects this problem by allocating interest expense to the bond payable each payment. That way the bond interest expense is always equal to the market interest rate of return. The theoretically preferable approach to recording amortization is the effective-interest method. Interest expense is a constant percentage of the bond’s carrying value, rather than an equal dollar amount each year. The theoretical merit rests on the fact that the interest calculation aligns with the basis on which the bond was priced. The effective interest rate is multiplied times the bond’s book value at the start of the accounting period to arrive at each period’s interest expense.
Although the company will make regular, equal interest payments each period, it will record different amounts in the interest expense category under the effective-interest method. To determine the amount to assign to interest expense each period under this method, multiply the effective interest rate (annual interest rate / number of payment periods per year) by the current book value of the bond.
In such a scenario difference between the amount paid and the book value of the bond is a discount and is amortized over the life of the bond. Every financial instrument carries a rate of interest, which is called a coupon rate paid annually, semi-annually to the bondholder. The effective interest rate calculation is commonly used in relation to the bond market. The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then the interest earned will decline also. Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate.
The effective interest amortization method is more accurate than the straight-line method. International Financial Reporting Standards require the use of the effective-interest method, with no exceptions. To record coupon payment on bondsNow that you understand the effective interest rate method of amortizing bond premiums and discounts we’ll move on to other long-term liabilities.
For example, Valenzuela bonds issued at a discount had a carrying value of $92,976 at the date of their issue. Although the straight-line method is simple to use, it does not produce the accurate amortization of the discount or premium. You can find the amount of discount amortization by taking the interest expense we calculated ($9,385.54) and subtracting the cash interest ($9,000), resulting in $385.54 of discount amortization in year one.
The interest on carrying value is still the market rate times the carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of discount amount is added to the carrying value. More frequently, businesses account for bond premiums or discounts under the effective interest method. This method is more mathematically complex, but can be done fairly quickly with the help of a finance calculator or Excel. The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period.
This account is created to adjust the discounted amount of the bond. You are the accountant of this company and your job is to maintain the accounts for this bond. Each year the amortization is subtracted from the carrying amount, and the new carrying amount is used to calculate interest expense and amortization for the next year.
- For example, a loan with 10 percent interest compounded monthly will actually carry an interest rate higher than 10 percent, because more interest is accumulated each month.
- Investors only demand an 8% return for owning the bond, and thus pay the company $106,710.08 for the bonds.
- The easiest way to calculate this value is by using an effective interest rate calculator.
- There are different types of bonds which have different characteristics that require different issuing procedures.
- This means that if you have a loan balance amounting to $8,000, you have to pay an amount of $3.20 of interest daily.
- Straight line amortization of premiums or discounts results in the same amount of interest expense, amortization, and cash interest in every single year until the bond is repaid.
Because the purchase price of bonds can vary so widely, the actual rate of interest paid each year also varies. For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market. Therefore, the bond discount of $5,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond. To demonstrate the usefulness of the effective rate, lets us take an example.
For example, consider a company that issues 10% bonds with a face value of $100,000 for $95,000. However, the difference between how much it has to ultimately repay in principal ($100,000) and the amount it received from selling the bonds ($95,000) represents an additional cost of financing.
This annual amortization amount is the discount on the bonds ($10,000) divided by the 10-year life of the bond, or $1,000 per year. Thus, the company will record $9,000 of interest expense, of which $8,000 is cash and $1,000 is the amortization of the discount. There are several online calculators that you can use to calculate the effective interest rate quickly. In addition, the EFFECT() function in Microsoft Excel will calculate the effective rate given the nominal rate and number of compounding periods. Interest expense is calculated as the effective-interest rate times the bond’s carrying value for each period.
Author: Barbara Weltman