What is the Effective Interest Method for Amortizing Bond Discounts and Bond Premiums?
On the CPA exam, bonds are similar to the Lion King as the effective interest method is can be thought of as the circle of life! The reality is that there are two major component of a bond that the FAR exam wants you to know about.
1. They want you to know the rules for calculating the bond itself and;
2. They want you to know how to value its discount/premium (remember these are presented separately!)
The big calculation is related to number 2 as the effective interest method is used for amortizing these bond discounts and bond premiums. Sort of like how you would depreciate tangible fixed assets, and exactly like how you would amortize intangible assets, you’re going to amortize discounts & premiums, and this is the method you’ll need to use!
Step 1) Determine the bonds beginning carrying value
Step 2) Calculate the periodic interest expense
Step 3) Calculate the periodic interest payment
Step 4) Calculate the discount/premium amortization expense
Step 5 Calculate the bonds ending carrying value for that period — this becomes the beginning carrying value for the next period (it’s the circle of life!)
Effective Interest Method:
The effective interest method is used for the amortization of unamortized bond discounts and bond premiums. The effective interest that the issuer will pay is determined in the existing market, not in the bonds contract. If the coupon rate exceeds the market rate, the bonds will be selling at a premium. If the market rate exceeds the coupon rate, the bonds will be selling at a discount. The issuance price is determined by discounting the payments to the present value by applying the effective interest rate method. This is required for United States Generally Accepted Accounting Principles (GAAP). Interest expense under the effective interest method is computed as follows:
Unamortized Premium & Discount:
CPA examiners will ask a candidate to calculate the “unamortized bond premium or discount”. Note that this amount is referring to the amount of the bond premium/discount that is yet to be amortized.
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