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### 13 2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method Principles of Accounting, Volume 1: Financial Accounting

The straight-line method allocates a fixed portion of the bond discount or premium each interest period to adjust the interest payment to interest expense. The interest payments on the obligation are qualified stated interest. Therefore, the sum of all amounts payable on the obligation (other than the interest payments) is \$100,000.

Valley collected \$5,000 from the bondholders on May 31 as accrued interest and is now returning it to them. Generally, a bond will come with a face value of \$1,000 or some other round number. However, the actual price paid to purchase the bond usually is not \$1,000. Based on market conditions, the price could be less than or greater than \$1,000.

Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value. This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium. However, the amount of interest expense reported in the income statement will differ from this value depending on whether the bond is issued at par, discount or premium. Each year, we add the amortization to the carrying value and repeat these steps to find the next year’s interest expense and discount amortization. Under the effective interest method, a company’s interest expense and amortization amount will change every single year.

It helps the issuer write off the same interest expense over the bond’s life and claim tax benefits. For the investor, the bond premium forms part of the cost of the bond. The effective interest rate method is commonly used for bond premiums amortization. Notice that under both methods of amortization, the book value at the time the bonds were issued (\$104,100) moves toward the bond’s maturity value of \$100,000. The reason is that the bond premium of \$4,100 is being amortized to interest expense over the life of the bond.

Under US GAAP both straight line and effective interest method are allowed but the effective interest method is preferred. 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. In each year, the interest payment is equal to coupon payment, that is USD 8 million. We will solve the problem assuming first the effective interest rate method, and then the straight-line method.

• An overview of these methods, using discount and premium examples, is given below.
• Also, the yield to maturity is stated in annual terms, so semi-annually the yield to maturity is 1.945% (3.89% / 2).
• One needs to calculate the number of bond premiums to amortize bond premiums.
• Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date.
• Volatility profiles based on trailing-three-year calculations of the standard deviation of service investment returns.
• The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan.
• The effective interest method is an accounting practice used to discount a bond.

Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. The net effect of creating the \$40,000 premium and writing off \$10,000 of it gives the company an interest expense of \$40,000 instead of \$50,000, since the \$50,000 expense is reduced by the \$10,000 premium write down at the end of the year. Effective interest amortization of premiumsPremiums are amortized in similar fashion to discounts under the effective interest method.

## Which of these is most important for your financial advisor to have?

When market interest rates decrease, for any given bond, the fixed coupon rate is higher relative to other bonds in the market. It makes the bond more attractive, and law firm bookkeeping it is why the bond is priced at a premium. When market interest rates rise, for any given bond, the fixed coupon rate is lower relative to other bonds in the market.

• However, each journal entry to record the periodic interest expense recognition would vary and can be determined by reference to the preceding amortization table.
• We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan.
• In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price.
• In addition, it will also record a charge for the amortization of the discount.
• The constant yield method amortizes the bond premium by multiplying the purchase price by the yield to maturity at issuance and then subtracting the coupon interest.

A bond trading for more than 100 would be priced for more than \$1,000; it is considered a premium. This method relates the interest expense for the period to the bond’s book value. The amount of interest decreases with a decrease in the bond’s book value. Volatility profiles based on trailing-three-year calculations of the standard deviation of service investment returns. This blog post was created as a part of the CFA exam review series to help you in your level 1 exam revision, whether done regularly or shortly before your CFA exam. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.

Straight line vs. effective interest methodThe 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. The term bonds issued at a premium is a newly issued debt that is sold at a price above par. When a bond is issued at a premium, the company typically chooses to amortize the premium paid by the straight-line method over the term of the bond. When a bond is issued at a price higher than its par value, the difference is called bond premium. The bond premium must be amortized over the life of the bond using the effective interest method or straight-line method.

Notwithstanding § 1.171–5(a)(1), paragraph (a)(4)(i)(C)(1) of this section applies to a bond acquired on or after January 4, 2013. A taxpayer, however, may rely on paragraph (a)(4)(i)(C)(1) of this section for a bond acquired before that date. This entry records \$5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.

The Premium must be amortized or written off by the company in its books of accounts over the bond’s life systematically. The amortization of bond premium refers to charging the Premium as a finance cost over the bond’s life. When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. 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. Once a bond has been issued and bonds payable liability has been created, the company will pay periodic interest payments to the bond holders for the life of the bond.