Long-Term Liabilities

Interest Rate Method of Amortization

The interest amortization method takes into account the purchase price of the bond, often used with discounts.
When bonds are sold at a premium or discount, the premium or discount is amortized over the life of the bond. Often the premium or discount is amortized using the straight-line method, which makes the amortization entry the same in every period. However, the effective interest rate method offers an alternative. The effective interest rate method takes into account the purchase price of the bonds and the carrying value of the bonds and the market rate of interest. Under the effective interest rate method, interest expense for each period is the carrying value of the bond times the effective interest rate. The amortization balances the difference between cash paid for interest and the calculated interest expense amount. This method of amortization is typically used with discounts because it takes into account the purchase price of the bond, rather than simply using the unamortized discount as a base for comparison. The carrying amount of the bond increases as interest is amortized under the effective interest method when the bond is issued at a discount.

Sample Amortization Table for Effective Interest Rate Method

End of Period Bond Carrying Amount Interest Expense at 6% Yield Cash Payment for Interest Amortization of Discount New Carrying Amount
1/1/2018 $4,550,000 $273,000 $250,000 $23,000 $4,573,000
6/30/2018 $4,573,000 $274,380 $250,000 $24,380 $4,597,380
12/31/2018 $4,597,380 $275,843 $250,000 $25,843 $4,623,223