Question

What is the difference between the straight-line and effective interest

rate methods of amortizing premiums and discounts?

Answer 1

		Straight Line Method	Effective interest rate method
1	Application	Easiest way to ammortize premiums and discounts.	Complex calculations
2	Amounts ammortized	Ammortized in equal amount over life of bond	Interest expense and Ammortized amount change every year
3	Usage	Less usage	Most widely used
4	calculation	Suppose a company issues $10000 of 5 year bonds that pay 6% annual coupon, bonds are sold at premium making it $11000. $1000 must be ammortized over 5 years. Thus, cash interest annual = 6%*10000 = $600. Premium ammortization = 1000/5 = $200. Thus, interest expense = 600-200 = $400. Similar for Discounts	If Bonds are issued at discount : First find the present value by using PVF Table, Second Multiply this amount by Rate of Return required to find interest expense, third find cash interest by multiplying coupon rate*bond's face value and resulting difference between interest expense and cash interest is the amount to be ammortized and similarly for premium.