 Concept 56: Effective Interest Rate Method and Amortization of Bond Discounts/Premiums | IFT World
101 Concepts for the Level I Exam

# Concept 56: Effective Interest Rate Method and Amortization of Bond Discounts/Premiums Under the effective interest rate method, interest expense = book value of the bond liability at the beginning of the period x market interest rate at issuance. The interest expense includes amortization of any discount or premium at issuance.

• The yield < coupon rate, therefore interest expense < coupon payment.
• The difference is subtracted from the bond liability on the balance sheet, which leads to amortization of the premium.

Discount bond:

• The yield > coupon rate, therefore interest expense > coupon payment.
• The difference is added to the bond liability on the balance sheet, which leads to amortization of the discount.

A firm issues $1 million bonds with a 5% coupon rate, 5-year maturity, and annual interest payments when market interest rates are 6%. Calculate the discount amortized in the first year. Solution: Since coupon rate < market rate, the bonds will be issued at a discount. Discounting the future payment to their present value indicates that at issuance the company will record an initial book value of$957,876.36.

The interest expense in the first year = Market interest rate at issuance x book value = 957,876.36 x 6% = $57,472.58 Discount amortized in first year = Interest expense – Coupon payment =$57,472.58 – $50,000 =$7,472.58

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