The Effective Interest Method: Unraveling Unamortized Bond Discount

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What is the Effective Interest Method?

• The preferred method for amortizing the bond discount is the effective interest rate method or the effective interest method.
• You can consider both rates as equivalent in a sense that both of them result in a single compound amount.
• GAAP requires entities to defer the recognition of fees, costs, premiums, and discounts over time instead of recognizing these items initially.
• From the perspective of a portfolio manager, the effective interest method allows for the anticipation of cash flows and the adjustment of strategies to meet long-term investment goals.

Similarly, if the nominal interest rate of 10% is compounded quarterly, the EAR is 10.38%, and if it’s compounded monthly, the EAR is equal to 10.47%. If the nominal interest rate is 10%, compounded annually, then the Annual Equivalent Rate is the same as 10%. On the other hand, if the nominal interest rate is 10% and is compounded once in six months, the EAR derived is 10.25%. Enhance your proficiency in Excel and automation tools to streamline financial planning processes. Learn through real-world case studies and gain insights into the role of FP&A in mergers, acquisitions, and investment strategies.

Straight-Line Amortization of Bond Discount on Annual Financial Statements

The methodical approach of HTM investments offers a safeguard against market volatility and reinforces the importance of strategic financial planning. To illustrate, consider a bond purchased at a discount with a face value of $1,000, a market interest rate of 5%, and a term of 5 years. Over the bond’s life, the interest expense recorded each year would increase as the carrying amount of the bond approaches its face value at maturity. For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon effective interest method in a 10% market. On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000). The cash interest payment is the amount of interest the company must pay the bondholder.

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• In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price.
• If however, the market interest rate is less than 9% when the bond is issued, the corporation will receive more than the face amount of the bond.
• A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.
• An amortization table calculates the allocation of interest and principal for each payment and is used by accountants to make journal entries.
• The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months.
• After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.

One nuance to think about is whether the interest rate for the term loan will remain the same throughout the contractual life of the debt or will change. If the interest rate will remain the same, this schedule can be set up at inception of the agreement with no changes subsequently required. If the interest rate will change (an example is if LIBOR is used), the schedule may need to be updated monthly. To update in this scenario, copy and paste values of all previous months, update the stated interest rate, and then re-run the Goal Seek formula.

Time Value of Money

• It is reasonable that a bond promising to pay 9% interest will sell for less than its face value when the market is expecting to earn 10% interest.
• A financial instrument issued at a premium means a buyer has paid more value than the par value of the financial instruments.
• Therefore, the amortization causes interest expense in each period to be greater than the amount of interest paid during each year of the bond’s life.
• Next, let’s assume that after the bond had been sold to investors, the market interest rate decreased to 8%.
• Present value calculations are used to determine a bond’s market value and to calculate the true or effective interest rate paid by the corporation and earned by the investor.
• These costs are referred to as issue costs and are recorded in the account Bond Issue Costs.
• Under IFRS the effective interest method is required for amortizing premiums, discounts, and transaction costs on financial instruments.

Subsequent changes in market rates do not affect the calculation of interest revenue for that particular bond. Assume that the loan was created on January 1, 2018 and totally repaid by December 31, 2022, after five equal, annual payments. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. 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 US GAAP, they are reported at the amount of the sales proceeds, ignoring any bond issuance costs. Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest. In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in https://www.bookstime.com/ the creation of their amortization documentation.

Each period, the interest income is calculated using the effective interest rate multiplied by the carrying amount of the bond at the beginning of the period. The difference between this interest income and the actual coupon payment is the amount of discount amortized. To illustrate, consider a bond with a face value of $1,000, purchased at $950, with a coupon rate of 5% and a maturity of 5 years. The effective interest rate would be calculated based on the purchase price and the expected cash flows. If the effective interest rate is found to be 6%, the interest income for the first year would be $57 (6% of $950), and the carrying amount of the bond would be adjusted accordingly.