University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

210

Pages:

1
Author:

stud_ice13

The effective interest method of amortization for bonds adjusts the bond's carrying value over time to reflect actual interest expense based on the market rate at the bond's issue date. Here’s how it works for both discount and premium bonds: Effective Interest Amortization for Discount Bonds: 1. Bond Interest Expense Calculation: For each period, the interest expense is calculated as the carrying value of the bond at the beginning of the period multiplied by the market rate of interest at issuance. 2. Amortization of Discount: Since the bond was issued at a discount, the carrying value starts below the par value. Each period, the difference between the bond interest expense and the cash paid for interest (calculated using the contract rate) is added to the carrying value, gradually increasing it. 3. Pattern: The interest expense increases over time because the carrying value increases as the discount is amortized. This continues until the carrying value equals the bond's par value at maturity. Effective Interest Amortization for Premium Bonds: 1. Bond Interest Expense Calculation: As with discount bonds, interest expense is determined by multiplying the beginning-of-period carrying value by the market rate at the issue date. 2. Amortization of Premium: When bonds are issued at a premium, the carrying value is above par. The cash payment for interest (calculated using the contract rate) exceeds the interest expense. The difference reduces the carrying value of the bond over time. 3. Pattern: The interest expense decreases as the bond's carrying value approaches par, and the amount of premium amortization increases with each period. Key Differences Between Effective Interest and Straight-Line Methods: • • Effective Interest Method: Allocates interest expense based on the bond's carrying amount and the market rate, leading to a changing interest expense and amortization amount over time. Straight-Line Method: Allocates the same interest expense and amortization amount to each period. Both methods ultimately result in the same total bond interest expense over the life of the bond, but they distribute the expense differently across periods. The effective interest method provides a more accurate representation of the bond's interest cost over time because it reflects changes in the bond's carrying value and interest expense.