What Is the Effective Interest Method of Amortization?
Under the effective interest method, a constant interest rate—equal to the market rate at the time of issue—is used to calculate the periodic interest expense.
Therefore, the interest rate is constant over the term of the bond, but the actual interest expense changes as the carrying value of the bond changes.
When you use the effective interest method, the carrying value of the bonds is always equal to the present value of the future cash outflow at each amortization date.
Effective Interest Method: Explanation
Although the straight-line method is simple to use, it does not produce the accurate amortization of the discount or premium.
It makes an unrealistic assumption: namely, that the interest cost for each period is the same, even though the liability’s carrying value is changing.
For example, under this method, each period’s dollar interest expense is the same. However, as the carrying value of the bond increases or decreases, the actual percentage interest rate correspondingly decreases or increases.
For example, Valenzuela bonds issued at a discount had a carrying value of $92,976 at the date of their issue.
The interest expense based on straight-line amortization for the period between 2 January 2020 and 1 July 2020 is $6,702. This results in an actual percentage interest rate of 7.2%, or $92,976.
In the next interest period, this rate falls to 7.15% because the interest expense for the period remains at $6,702. However, as shown in our article covering bonds issued at a discount, the carrying value of the bonds has increased to $93,678.
As a result, the percentage interest rate is now 7.15 (or $6,702 / $93,678).
Over the life of the bond, this percentage interest rate continues to decrease until 2 January 2025, when it reaches 6.7% (or $6,702 / $99,294).
In the premium example, the same conceptual problem occurs, except that the percentage rate continuously increases as the carrying value of the bond decreases from $107,722 to $100,000.
At the same time, the semiannual interest expense remains constant at $5,228.
Due to the straight-line method’s conceptual problem, the Financial Accounting Standards Board (FASB) requires the use of the effective interest method unless there are no material differences between the two.
Let’s now consider how to use the effective interest method for both the discount and premium cases.
Amortization Under Effective Interest Method
As illustrated, the $1,007,000, 5-year, 12% bonds issued to yield 14% were sold at a price of $92,976, or at a discount of $7,024. The table below shows how this discount is amortized using the effective interest method over the life of the bond.
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.
In this case, the interest expense of $6,508 in Column 2 on 1 July 2020 is equal to $92,976 multiplied by 7%.
The difference between the required cash interest payment of $6,000 in Column 3 ($100,000 x 6%) and the effective interest expense of $6,508 is the required discount amortization of $508 in Column 4.
Finally, the unamortized discount of $6,516 on 1 July 2020 in Column 5 is equal to the original discount of $7,024, less the amortized discount of $508. The bond’s carrying value in Column 6 is thus increased by $508, from $92,976 to $93,484.
Alternatively, the bond’s carrying value on 1 July 2020 is equal to the unamortized discount of $6,516.
The information for the journal entry to record the semiannual interest expense can be drawn directly from the amortization schedule. The entry for 1 July 2020 is shown below.
The following table compares two different methods of discount amortization for the first three interest periods and the total over the 10 periods:
As the table shows, the interest for each period is $6,702 and the total over the 10 periods is $67,024 under the straight-line method.
Under the effective interest method, the semiannual interest expense is $6,508 in the first period and increases thereafter as the carrying value of the bond increases.
With the effective interest method, as with the straight-line method, the total interest expense is $67,024. Importantly, there is no difference in the total interest expense within the 5-year period of time; there is only a difference in the allocation.
The partial balance sheet from our article on bonds issued at a premium shows that the $100,000, 5-year, 12% bonds issued to yield 10% were issued at a price of $107,722, or at a premium of $7,722.
The schedule below shows how the premium is amortized under the effective interest method.
This schedule is set up in the same manner as the discount amortization schedule in the above exhibit, except that the premium amortization reduces the cash interest expense every period.
For each period, the interest expense in Column 2 is the semiannual yield rate at the time of issue, 5%, multiplied by the carrying value of the bonds at the beginning of the period.
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.
The journal entry to record the semiannual interest expense can be drawn directly from this schedule. The entry on the 1st July 2020, is:
As with the discount example, the total interest expense over its lifetime under the straight-line and the effective interest methods is the same. However, it is allocated differently among the periods.
In both the discount and premium, the difference between the straight-line and the effective interest amortization methods is not significant. However, for large bond issues, this difference can become significant.
If this is the case, accepted accounting principles require that you should use effective interest amortization.