Period The period used to define the frequency of the amortization Number of Periods Used with period to define the frequency of the amortization. Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. There was no premium or discount to amortize, so there is no application of the effective-interest method in this example. Knowing this, you’ll notice that the straight line method will result in more discount or premium amortization during earlier years than the effective interest method. Conversely, the effective interest method results in more amortization in later years than the straight line method.
Investors are willing to pay a premium for the bond in order to secure higher interest income. The effective interest method is the method used by a bond buyer to account for accretion of a bond discount or to amortize a bond premium. The effective interest rate calculation is commonly used in relation to the bond market. The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then the interest earned will decline also. If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%.
Under the effective interest method, theeffective interest rate, which is a key component of the calculation, discounts the expected future cash inflows and outflows expected over the life of a financial instrument. In short, the interest income or expense recognized in a reporting period is the effective interest rate multiplied by the carrying amount of a financial instrument. Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, such as the 30-year U.S. Treasury bond, although the same principles apply to corporate bond trades. When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interest rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value.
This method is more mathematically complex, but can be done fairly quickly with the help of a finance calculator or Excel. The coupon rate a company pays on a bond is the most obvious cost of debt financing, but it isn’t the only cost of financing.
In any event, when the bond reaches maturity, both the straight-line amortization and the effective interest rate method of calculating amortization will be equal. However, the effective interest method requires more work because it needs to be recalculated for every individual interest-earning period. Therefore, it is commonly only used when a bond is purchased at a significant premium or discount or when the bond’s book value increases or decreases significantly during the life of the bond. The effective interest method is a technique used for amortizing bonds to show the actual interest rate in effect during any period in the life of a bond prior to maturity. Bonds are typically sold at a premium to their face value when the bond’s stated interest rate is greater than prevailing market rates.
If you always sold bonds at face value, you’d never need to bother with amortization. In the real world, amortization accounts for the difference between what you collect and what you pay back. Straight line amortization is widely considered to be a simpler method of account for bond values than effective interest amortization. While straight-line amortization divides the bond’s total premium over the remaining payment periods, effective interest is used compute unique values at all points of repayment. Period-end carrying amount of a financial asset/liability is determined by adding/subtracting discount/premium amortized during a period to opening carrying amount.
On the other hand, if the book value decreases, then the actual interest earned goes down, too. Therefore, the actual interest earned over the life of a bond to maturity can deviate significantly from the stated interest rate.
That way the bond interest expense is always equal to the market interest rate of return. In both the discount and premium, the difference between the straight-line and the effective interest amortization methods is not significant. However, for large bond issues, this difference can become significant. The difference between this amount and the cash interest in Column 3 is the premium amortization in Column 4. The bond’s carrying value at the end of the period in Column 6 is reduced by the premium amortization for the period. The partial balance sheet from our article on bonds issued at a premium shows that the $100,000, 5-year, 12% bonds issued to yield 10% were issued at a price of $107,722, or at a premium of $7,722. Of the bond will reach the par value of the bond and is paid to the bondholder.
To record coupon payment on bondsNow that you understand the effective interest rate method of amortizing bond premiums and discounts we’ll move on to other long-term liabilities. For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered.
Second, divide the result by the number of bond payments remaining before the bond matures. Third, add the interest received per bond payment by the result. It was therefore designated by the APB as the preferred method of amortization.
In our example, there is no accrued interest at the issue date of the bonds and at the end of each accounting year because the bonds pay interest on June 30 and December 31. The entries for 2020, including the entry to record the bond issuance, are shown next. A bond purchased at a premium generates a larger cost of debt for the bond buyer, because the premium paid is amortized into bond expense.
The carrying value of the bonds at the beginning of the period by the effective interest rate. I made an Excel template that you can use as the effective interest method of amortization calculator. In other words, the effective interest rate is the internal rate of return of the financial asset or liability. In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. She will repay the loan with five equal payments at the end of the year for the next five years.
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. They are sold at a discount to provide interest to the buyer.
We will illustrate the problem by the following example related to a premium bond. If period is set to days and number of periods is set to 5, the calculations above would be run every five days. You simply specify the exact dates on which portions of the fee are scheduled to be amortized then you specify the exact amount to be amortized on each of those dates. The ever-changing technological environment can lead to new and improved products and services for businesses that embrace new technology, while those that resist technological change risk being left behind. Explore examples of what can happen in either case and learn how technological change sometimes causes creative destruction by rendering existing technologies obsolete. There are different types of bonds which have different characteristics that require different issuing procedures.
Under the effective interest method, a company’s interest expense and amortization amount will change every single year. The cash interest is calculated by taking the coupon rate of the bond (9%) and multiplying it by the bond’s face value ($100,000), resulting in $9,000 of cash interest. In the first period, we record $93,855.43 as the carrying amount of the bond. To calculate total interest expense for the first year, we take the carrying amount of the bond and multiply it by investors’ required return of 10%. Solve for present value to get $93,855.43, or the amount investors will pay for these bonds if they want a 10% annual return, also known as a yield to maturity. Suppose a company sells $100,000 in 10-year bonds with an annual coupon of 9% at a discount to face value. Investors demand a 10% annual return to buy the bond, and thus will only pay $93,855.43 for the bonds.
The effective interest amortization method is more accurate than the straight-line method. International Financial Reporting Standards require the use of the effective-interest effective interest method of amortization method, with no exceptions. When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond.
In such a scenario, the coupon rate is equal to the market rate. Since carrying the value of the bond is exactly equal to the par value of the bond, the effective interest method is not applicable. Normal journal entries will be passed on the issuance of bonds, accrual, and payment of interest, payment of principal amount at maturity. Effective interest method is the method of amortizing the discount on bonds or premium on bonds payable. In this method, interest expense is calculated on the basis of the market rate or the effective interest rate.
The $10,000 difference between the sales price and the face value of the bond must be amortized over 10 years. Each year, the company will have to pay $8,000 in cash interest (coupon rate of 8% X $100,000 in face value). In addition, it will also record a charge for the amortization of the discount. This annual amortization amount is the discount on the bonds ($10,000) divided by the 10-year life of the bond, or $1,000 per year. Thus, the company will record $9,000 of interest expense, of which $8,000 is cash and $1,000 is the amortization of the discount. Suppose a company issues $100,000 of 10-year bonds that pay an 8% annual coupon.
Learn about secured and unsecured bonds, term and serial bonds, registered and bearer bonds, and convertible and callable bonds. Note that the last amortization amount was adjusted slightly to fully amortize the premium. I’m trying to calculated amortization using your template but unfortunately i didn’t get the figures.
In other words, it reflects what the change in the bond price would be if we assumed that the market discount rate doesn’t change. Straight Line PeriodicRemainder of the amortized fee is canceled while the pro-rata rate of the amortization fee is reversed. Rebate rule is applicable.Principal/Original Balance ProRata MethodThe unamortized balance is canceled.Rule of 78Remainder of the amortized fee is canceled.
Author: Gene Marks