Effective Interest Method: Bond Premium & Discount
Tutorly · Financial Accounting
Effective Interest Method: Bond Premium & Discount
Under the effective interest method, each period’s interest expense = the bond’s carrying value × the market rate at issue. The cash coupon is fixed; the difference between expense and coupon is the premium or discount amortized, which moves the carrying value toward face. The common mistake is using the coupon rate for expense — it’s always the market rate on the carrying amount.
The setup
A company issues a $100,000, 3-year bond with a 5% annual coupon when the market rate is 6%. Because 5% < 6%, it sells at a discount.
PV of coupons: $5,000 × annuity factor (3 yr, 6%) = $5,000 × 2.6730 = $13,365.
PV of face: $100,000 × 0.8396 = $83,962.
Issue price = 13,365 + 83,962 = $97,327 → discount of $2,673.
| Cash | 97,327 | |
| Bonds payable (net) | 97,327 |
The amortization table
| Year | Opening carrying | Interest exp (6%) | Coupon (5%) | Discount amort. | Closing carrying |
|---|---|---|---|---|---|
| 1 | 97,327 | 5,840 | 5,000 | 840 | 98,167 |
| 2 | 98,167 | 5,890 | 5,000 | 890 | 99,057 |
| 3 | 99,057 | 5,943 | 5,000 | 943 | 100,000 |
| Interest expense | 5,840 | |
| Cash | 5,000 | |
| Bonds payable (net) | 840 |
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Frequently asked questions
How does the effective interest method work?
Each period, interest expense = the bond’s opening carrying value × the market (effective) rate at issue. The gap between that and the cash coupon is the premium or discount amortized, adjusting the carrying value toward face.
Why use the market rate, not the coupon rate?
Because the effective method reflects the real cost of borrowing — the rate investors actually demanded at issue — applied to the amount still owed (the carrying value).
What’s the difference between a premium and a discount?
A discount means the bond sold below face (coupon < market); a premium means it sold above face (coupon > market). Both amortize to face by maturity.
Is the effective interest method required?
Under IFRS, yes — the effective interest method is required; the older straight-line method isn’t permitted for public companies.
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