When amortizing a premium the effective interest method will yield greater

When amortizing a premium the effective interest

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When amortizing a premium, the effective interest method will yield greater interest expense in the earlier years over the straight-line method. Overall, the two methods will yield the SAME TOTAL amount, because we have to amortize the discount UP TO face value or the premium DOWN TO face value. It’s just that, depending on the method used, one method will yield higher amounts than the other in earlier years and less in the later years. (FYI, this is what is known as differences in timing of amounts, which you will learn more about when you do taxes. Don’t confuse interest EXPENSE with the AMOUNT OF premium or discount amortized each period. The amount amortized is the difference between the interest paid (in cash) each period and the interest expense recognized each period. Regardless of whether you are amortizing a discount or premium, the straight line will amortize more of the discount/premium in earlier years than the effective method. Look back at the examples above. Under the straight line method, the interest expense for July 2011 was: 1-Jul-11 Bond Interest Expense 39,600 Under the effective interest method, the interest expense for the same time period was: 1-Jul-11 Bond Interest Expense 39,864 As you can see, the interest expense is higher in the earlier years under the effective interest method. Let’s look at a problem where we’re amortizing a discount: E14-6 (Amortizat ion Schedule s - Straight line) Spencer
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Company sells 10% bonds having a maturity value of $3,000,00 0 for $2,783,72 4 . The bonds are dated January 1, 2010, and mature January 1, 2015. Interest is payable annually on January 1. Instructio ns: Set up a schedule of interest expense and discount amortization under the straight-line method. Sc hedule of Discount Amortizati on Straight- Line Method (a) (b) © (d) (e) Credit Debit Credit Carrying Interest Interest Bond Value of Year Payable Expense Discount* Bonds (or cash) (10% of Col (b)+ See below Previous carrying value of maturity Col (d) for calc bond + Col (d) value) 1-Jan-10 $2,783,72 4 31-Dec-10 $300,000 $343,255. 20 $43,255.2 0 $2,826,97 9.20 31-Dec-11 $300,000 $343,255. 20 $43,255.2 0 $2,870,23 4.40 31-Dec-12 $300,000 $343,255. 20 $43,255.2 0 $2,913,48 9.60 31-Dec-13 $300,000 $343,255. 20 $43,255.2 0 $2,956,74 4.80 31-Dec-14 $300,000 $343,255. 20 $43,255.2 0 $3,000,00 0.00
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*To calculate the "credit bond discount" column, we take the maturity value of the bond ($3,000,000) less the sale price of the bond ($2,783,724). This amount is $216,276. We then divide this by the life of the bond (2010 - 2015 is 5 years). This amount is $43,255.20. Now, let’s compare this to the effective interest method: E14-7 Amortizati on Schedule - Effective Interest) Spencer Company sells 10% bonds having a maturity value of $3,000,000 for $2,783,724 . The bonds are dated January 1, 2010, and mature January 1, 2015. Interest is payable annually on January 1. Instructions Set up a schedule of interest expense and discount amortization under the effective interest method. The effective-interest or yield rate is 12%. It is determined through trial and error using Table 6-2 for the discounted value of the principal ($1,702,290) and Table 6-4 for the discounted value of the interest ($1,081,434); $1,702,290 plus $1,081,434 equals the proceeds of $2,783,724.
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