Amortization of Bond Discount: Effective Interest Method

Under effective interest method of amortization of bond discount, the bond discount amortized each year is equal to the difference between the interest expense based on the product of market interest rate and the carrying amount of the bond and the interest payable based on the product of the stated coupon rate and face value.

Illustration

Company DS intended to issue a bond with face value of $100,000 having a maturity of 5 years and annual coupon of 8%. At the time of issue however, the market interest rate rose to 10% and the bond could fetch a price of $92,420 only.

For the first year, the interest expense is based on the market interest rate of 10% and the carrying amount of the bond of $92,420 and it equals $9,242. Interest paid or payable on the other hand is based on the stated interest rate of 8% and the face value of $100,000 and it equals $8,000. The amortization of bond discount for the first year is simply the difference between these two figures and it equals $1,242. Company SD would record the amortization and interest expense using the following journal entry:

Interest expense9,242
Interest payable8,000
Bond discount1,242

In year 2 the carrying amount would be $93,662 ($92,420 plus the amortized bond discount of $1,242). This would lead to interest expense of $9,366. Since interest paid or payable would be the same i.e. $8,000 this would lead to a higher figure for bond discount amortized during the period. Company SD would require the following journal entry:

Interest expense9,336
Interest payable8,000
Bond discount1,336

We notice that under the effective interest method the amount of bond discount amortized increases over the life of the bond.

Effective interest method is the preferred method for bond discount amortization as compared to straight line method.

Written by Obaidullah Jan