Question

Why might a corporation prefer double-declining balance as its method of depreciation?

Why is the effective interest rate method of amortizing bond discount and premium accepted as GAAP rather than straight-line method?

Answer 1

The double declining balance depreciation (DDB) method is one of two common methods a business uses to account for the expense of a long-lived asset. The double declining balance depreciation method is an accelerated depreciation method that counts as an expense twice as much of the asset’s book value each year compared to straight-line depreciation.

DDB Depreciation Formula

Depreciation=2×SLDP×BV

where:SLDP = Straight-line depreciation percent

BV = Book value at the beginning of the period​

The Effective Interest Rate Method

The preferred method for amortizing (or gradually writing off) a discounted bond is the effective interest rate method or the effective interest method. Under the effective interest rate method, the amount of interest expense in a given accounting period correlates with the book value of a bond at the beginning of the accounting period. Consequently, as a bond's book value increases, the amount of interest expense increases.

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. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. 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.

For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market. The bond is sold at a discount for $95,000 on January 1, 2017. Therefore, the bond discount of $5,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond.

The effective interest method of amortization causes the bond's book value to increase from $95,000 January 1, 2017, to $100,000 prior to the bond's maturity. The issuer must make interest payments of $3,000 every six months the bond is outstanding. The cash account is then credited $3,000 on June 30 and December 31.

A Bond's Par Value

Par value, in turn, is simply another term for the bond's face value, or the stated value of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year.

A bond's par value does not dictate its selling price. Bonds that have higher coupon rates sell for more than their par value, making them premium bonds. Conversely, bonds with lower coupon rates often sell for less than par, making them discount bonds. Because the purchase price of bonds can vary so widely, the actual rate of interest paid each year also varies.

If the bond in the above example sells for $800, then the $60 interest payments it generates each year actually represent a higher percentage of the purchase price than the 6% coupon rate would indicate. Though both the par value and coupon rate are fixed at issuance, the bond actually pays a higher rate of interest from the investor's perspective. The effective interest rate of this bond is $60 / $800 or 7.5%.

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%. While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate.