What Is the Effective Interest Method of Amortization?

If the bond is issued at a premium or discount, the premium or discount is amortized systematically over the life of the bonds as a component of interest expense. Determine the market price of a $1,500,000, 12-year, 9% bond issue sold to yield an effective rate of 8%. Also, determine the amount of any possible bond premium or discount.

For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly. Unlike the real interest rate, the effective interest rate does not account for inflation. For borrowers, the effective interest rate shows costs more effectively. The corporation must make an interest payment of $4,500 ($100,000 x 9% x 6/12) on each June 30 and December 31. This means that the Cash account will be credited for $4,500 on each interest payment date. Learn more about this topic, accounting and related others by exploring similar questions and additional content below. Hearst Newspapers participates in various affiliate marketing programs, which means we may get paid commissions on editorially chosen products purchased through our links to retailer sites.

A Bond’s Par Value

In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding. Premium amortization is a method that spreads the total premium amount received when issuing a bond in a series of periodic payments that are based on the effective interest rate.

Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant. The interest expense in column C is the product of the 4% market interest rate per semiannual period times the book value of the bond at the start of the semiannual period. Notice how the interest expense is decreasing with the decrease in the book value in column G. This correlation between the interest expense and the bond’s book value makes the effective interest rate method the preferred method. You want to borrow $100,000 for five years when the interest rate is 5%. Assume that the loan was created on January 1, 2018 and totally repaid by December 31, 2022, after five equal, annual payments.

CFR § 1.171-2 – Amortization of bond premium.

In the case of a tax-exempt obligation, if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is a nondeductible loss. A holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period. This offset occurs when the holder takes the qualified stated interest into account under the holder’s https://www.bookstime.com/ regular method of accounting. The bonds have a term of five years, so that is the period over which ABC must amortize the premium. Whenever an investor buys, or a financial entity such as the U.S. Treasury or a corporation sells, a bond instrument for a price that is different from the bond’s face amount, the actual interest rate earned is different from the bond’s stated interest rate. The bond may be trading at a premium or at a discount to its face value.

In the straight line amortization method, the bond’s carrying value changes each period while the bond interest expense each period remains the same. This displays a changing interest rate when the carrying value fluctuates each period while interest remains the same. Thus, the accounting handbooks advise to only use this rule when the results do not differ significantly from the effective interest method. The effective interest method allocates bond interest expense over the life of the bonds in such a way that it yields a constant rate of interest, which in turn is the market rate of interest at the date of issue of bonds. With effective interest method, the bond payable and discount/premium is calculated using the effective market interest rate versus the coupon rate used in straight-line method. Below is the amortization schedule for this bond issue using effective interest. In the EIRA, you figure each amortization payment by reducing the balance in the premium on bonds payable account by the difference between two terms.

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While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate. Premium amortization of bond premium effective interest method BondsA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value.

• 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.
• The accounting treatment for Interest paid and bond premium amortized will remain the same, irrespective of the method used for amortization.
• This means that the Cash account will be credited for $4,500 on each interest payment date.
• The second term is the prevailing semi-annual rate at the time of issue, which is 4 percent in the example, times the previous period’s book value of the bonds.
• 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.
• Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest.

In each year, the interest payment is equal to coupon payment, that is USD 8 million. D) a smaller amount of interest income over the life of the bond issue than would result from the use of the straight-line method.

Face value is the nominal value or dollar value of a security stated by the issuer, also known as “par value” or simply “par.” Par value can refer to either the face value of a bond or the stock value stated in the corporate charter.