Learning Effective Interest Amortization of a Discount Bond

The straight-line method yields changes in the bonds’ carrying value while the amount for bond interest expense remains constant. This gives the impression of a changing interest rate when users divide a constant bond interest expense over a changing carrying value. As a result, accounting standards allow use of the straight-line method only when its results do not differ materially from those obtained using the effective interest method.

The effective interest method Allocates interest expense over the bond life to yield a constant rate of interest; interest expense for a period is found by multiplying the balance of the liability at the beginning of the period by the bond market rate at issuance; also called interest method., or simply interest method, allocates total bond interest expense over the bonds’ life in a way that yields a constant rate of interest. This constant rate of interest is the market rate at the issue date. Thus, bond interest expense for a period equals the carrying value of the bond at the beginning of that period multiplied by the market rate when issued.

Point: The effective interest method computes bond interest expense using the market rate at issuance. This rate is applied to a changing carrying value.

Exhibit 14B.1 shows an effective interest amortization table for the Fila bonds (as described in Exhibit 14.4). The key difference between the effective interest and straight-line methods lies in computing bond interest expense. Instead of assigning an equal amount of bond interest expense to each period, the effective interest method assigns a bond interest expense amount that increases over the life of a discount bond.  

Both methods allocate the same $19,546 of total bond interest expense to the bonds’ life, but in different patterns.

Specifically, the amortization table in Exhibit 14B.1 shows that the balance of the discount (column D) is amortized until it reaches zero. Also, the bonds’ carrying value (column E) changes each period until it equals par value at maturity. Compare columns D and E to the corresponding columns in Exhibit 14.7 to see the amortization patterns. Total bond interest expense is $19,546, consisting of $16,000 of semiannual cash payments and $3,546 of the original bond discount, the same for both methods.

EXHIBIT 14B.1 Effective Interest Amortization of Bond Discount