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 preferred method for amortizing the bond premium 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 year will correlate with the amount of the bond’s book value. This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium.

The payment itself ($2,773.93) is larger than the interest owed for that period of time, so the remainder of the payment is applied against the principal. In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation. In both the discount and premium, the difference between the straight-line and the effective interest amortization methods is not significant. With the effective interest method, as with the straight-line method, the total interest expense is $67,024.

What is a discount amortization?

The bond must have been issued at a discount to compensate the bondholders for getting an interest rate lower than the market interest rate for bonds with similar risk and maturity. In its simplest form, discount amortization is a process used to allocate the discount on bonds, or other long-term debt, evenly over the life of the instrument. As with the discount example, the total interest expense over its lifetime under the straight-line and the effective interest methods is the same. The difference between this amount and the cash interest in Column 3 is the premium amortization in Column 4. The bond’s carrying value at the end of the period in Column 6 is reduced by the premium amortization for the period.

Using the same format for an amortization table, but having received $91,800, interest payments are being made on $100,000. For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium.

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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. The effective interest method is an accounting practice used to discount a bond. This method is used for bonds sold at a discount or premium; the amount of the bond discount or premium is amortized to interest expense over the bond’s life. Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.

By selecting bonds with favorable tax treatment, such as municipal bonds, and managing bond premium amortization, investors can optimize their portfolios for tax efficiency. Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. There was no premium or discount to amortize, so there is no application of the effective-interest method in this example.

Part 4: Getting Your Retirement Ready

The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. By grasping the concept of bonds sold at a when the effective interest rate method is used, the amortization of the bond premium premium and the relationship between bond prices and interest rates, investors can better comprehend the bond market. The theoretically preferable approach to recording amortization is the effective-interest method. Interest expense is a constant percentage of the bond’s carrying value, rather than an equal dollar amount each year.

Assume that Discount Corp. issues 100, five-year, semi-annual, $1,000 bonds with an 8% coupon during a period of time when the market rate is 10% and so receives $92,278 because the coupon rate is lower than the market rate. In this table, the effective periodic bond interest expense is calculated by multiplying the bond’s carrying value at the beginning of the period by the semiannual yield rate, determined at the time the bond was issued. 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.