Question

how does the effective interest method for a bond discount or premium differ from straight-line amortization? why does GAPP require this method?

Answer 1

The effective interest method for bond amortization calculates the interest expense based on the market interest rate. The discount or premium amortized is based on interest expense calculated on Bond carrying value and cash interest paid. In a straight line amortization method the premium or discount on issue of bonds is amortized on straight line basis over the terms of interest payment. The discount or premium on issue of bonds is calculated based on difference between bond face value and bond issue price. The amortization amount is constant in straight line method compared to effective interest method which carries based on carrying value of bond

GAAP requires the effective interest rate method since market rate of interest is the effective cost of borrowing and the charge of interest expense is based on the carrying value of bond which reflects the actual interest cost. As carrying value of bond increases or decrease the interest expense reflects the similar charge to income statement. When bonds are issued at premium the annual interest expense will decrease over the tenure of bond and when bonds are issued at discount the annual interest expense will increase over the tenure of bond.