The Effective Interest Method CFA Level 1

amortization of bond premium effective interest method

The coupon rate a company pays on a bond is the most obvious cost of debt financing, but it isn’t the only cost of financing. The price at which a company sells its bonds — and the resulting premium or discount — is an important factor, and it must be accounted for.

amortization of bond premium effective interest method

The cash account is then credited $3,000 on June 30 and December 31. Bonds PayableBonds payable are the company’s long-term debt with the promise to pay the interest due and principal at the specified time as decided between the parties. A bond payable account is credited in the books of accounts with the corresponding debit to the cash account on the issue date.

SLA — Discount Bonds

The bond provides for unconditional payments of interest of $10,000, payable on February 1 of each year. A uses the cash receipts and disbursements method of accounting, and A decides to use annual accrual periods ending on February 1 of each year. The company reports such interest expense of amortization every year to calculate the exact amount of interest income from the bond investment. This method helps to report the effective interest rate, the same is used in the book valuation of the bond to calculate the interest income. The initial journal entry to record the issuance of the bonds, and the final journal entry to record repayment at maturity would be identical to those demonstrated for the straight-line method. For example, consider an investor that purchased a bond for $10,150.

amortization of bond premium effective interest method

The Straight Method is preferable when the premium amount is very less or insignificant. For the remaining 7 periods, we can use the same structure presented above to calculate the amortizable bond premium. It can be seen from the above example that a bond purchased at a premium has a negative accrual, or in other words, the basis of the bond amortizes. 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. Under the effective interest method, the semiannual interest expense is $6,508 in the first period and increases thereafter as the carrying value of the bond increases. Shows an amortization table for this $10,000 loan, over five years at 12% annual interest.

What is the Amortization of Premium on Bonds Payable?

The effective interest rate calculation reflects actual interest earned or paid over a specified timeframe. When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. Therefore, the amortization causes interest expense in each accounting period to be higher than the amount of interest paid during each year of the bond’s life. When the effective-interest method of bond premium amortization is used, the O interest rate used to calculate interest expense will be the contractual rate.

  • If an investor uses the simpler straight-line method to calculate interest, then the amount charged off each month does not vary; it is the same amount each month.
  • For instance, as the bond payments are made, interest is being expensed and the bond premium or discount is reducing or increasing the loan balance.
  • Whirlie Inc. issued $300,000 face value, 10% paid annually, 10-year bonds for $319,251 when the market of interest was 9%.
  • The fun light-hearted analogies are also a welcome break to some very dry content.
  • This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest.
  • Carrying value of the bonds will increase with successive amortization.
  • Though the total to be paid is known, allocation to specific time periods may be uncertain.

To calculate this number, we divide $54,090 by 4 giving us a total bond interest expense of $13,522.50 per period . Thus, the company would record $8,000 in cash interest annually (coupon rate of 8% X $100,000 in face value). In addition, it would record premium amortization of $1,000 per year ($10,000 in premium divided by the 10-year life of the bond). Interest expense is $7,000 each amortization of bond premium effective interest method year (cash interest of $8,000 minus $1,000 of premium amortization). A company issues $1,000,000 face value of seven-year bonds when the market interest rate is 5%. The sales proceeds is $942,136 and the bond pays 4% interest annually. If a bond is issued at face value, the amount of periodic interest expense will be the same as the amount of periodic interest payments to bondholders.

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