fbpixel
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.

Premium bond:

  • 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