Question

In your own words, describe why the FASB prefers the effective interest method of amortizing the bond premium. Provide the FASB Codification number that supports your opinion. "

Answer 1

Effective interest method is a method used for amortization of bond premium. This method is applied when bonds are sold at discount. The discount is amortized over the useful life of bond. It is one of the widely used method for writing off a bond. Under this method, as the book value of the bond takes hike, its interest expense also increased or as the book value of the bond takes a downfall its interest expense also decreases.

In this method the basic entry be:

Discount on bonds payable Dr

To interest expense

Interest in initial years is lower and keeps on increasing to the life of the asset. Some of the bonds have no interest rate commonly referred to as zero coupon bonds and only principal amount is paid at maturity. Some bonds have a rate called a coupon rate and creates interest on the par value of the bond.

This method is more effective than the straight line method in a way that in straight line method the interest expense remains constant and divided equally to the life of bond. But in effective interest interest expense keeps on increasing.

According to FASB interest is prescribed in section 835.

835(10) denotes all interest expenses and income values and their calculations. It gives insights on how to recognise the amount of interest for a particular period.

Similarly 835(20) denotes the computation of interest and 835 (30) denotes imputation of interest.