Question

Effective Interest Amortization of Premiums and Discounts

The appropriate method of amortizing a premium or discount on issuance of bonds is the effective interest method.

Required:

1. What is the effective interest method of amortization, and how is it different from or similar to the straight‐line method of amortization?
2. How are interest and the amount of discount or premium amortization computed using the effective interest method, and why and how do amounts obtained using the effective interest method differ from amounts computed under the straight‐line method?
3. Generally, the effective interest method is defended on the grounds that it provides the appropriate amount of interest expense. Does it also provide an appropriate balance sheet amount for the liability balance? Why, or why not?

Answer 1

Effective interest method is used to amortized the discount or premium on issue of bonds. The effective interest method uses carrying value of bond and yield to maturity. Under straight line method, the amount of premium or discount amortized remains same each year while under effective interest method the amount of premium or discount amortization would differ.

Under effective interest method, the interest is calculated as yield to maturity multiplied by carrying value of bonds at beginning of the year. The amount of discount or premium amortized is calculated as difference between interest expense and coupon amount paid. This amortized amount is then deducted from carrying value of bond. Under straight line method the premium or discount amortization is calculated as total discount or premium divided by number of years in maturity of bond. The amortized amount is than used to calculate the interest expense which is interest expense plus(minus) coupon amount. The interest amount and amortization amount remains same in straight line method while in effective interest method it differs.

Effective interest method has advantage over straight line method. Effective interest method gradually helps to decrease the liability of company and it arrives at the same results at straight line method in total. It shows the actual amount of liability outstanding over the life of bond when there is repayment made.