What Is The Effective Interest Method Of Amortization
Under the effective interest method, a constant interest rate, equal to the market rate at the time of issue, is used to calculate periodic interest expense. Thus, the interest rate is constant over the term of the bond, but the actual interest expense changes as the carrying value of the bond changes. Furthermore, when the effective interest method is used, the carrying value of the bonds will always be equal to the present value of the future cash outflow at each amortization date.
Although the straight-line method is simple to use, it does not produce the accurate amortization of the discount or premium. It makes the unrealistic assumption that the interest cost for each period is the same, even though the carrying value of the liability is changing. For example, under this method, each period’s dollar interest expense is the same, but as the carrying value of the bond increases or decreases, the actual percentage interest rate correspondingly decreases or increases. For example, the Valenzuela bonds issued at a discount (click to see example) had a carrying value of $92,976 at the date of their issue. The interest expense based on straight-line amortization for the period between January 2, 2020, and July 1, 2020, is $6,702.
This results in an actual percentage interest rate of 7.2%, or $92,976. In the next interest period, this rate falls to 7.15% because the interest expense for the period remains at $6,702, but as shown in Exhibit (bonds issued at a discount), the bond’s carrying value has increased to $93,678. As a result, the percentage interest rate is now 7.15% Or $6,702 / $93,678. Over the life of the bond, this percentage interest rate continues to decrease until January 2, 2025, when it reaches 6.7%, or $6,702 / $99,294.
In the premium example, the same conceptual problem occurs, except that the percentage rate continuously increases as the carrying value of the bond decreases from $107,722 to $100,000, whereas the semiannual interest expense remains constant at $5,228.
Because of the conceptual problem with the straight-line method, the Financial Accounting Standards Board (FASB) required that the effective interest method be used unless there are no material differences between the two. We will illustrate the effective interest method for both the discount and the premium cases.