Loading...

Thursday, December 17, 2009

Effective Interest Method

Dear Visitor

Thanks for reading my blog and being a part of it. Every encouraging word received from my readers  strengthens and motivates me to work with novel energy and commitment.

Today, I will converse on one of my favorite topics Effective Interest Method. This is a pervasive term and its application impacts recognition of Debentures, Bonds and Lease Obligations in the financial statements. I will try to keep the discussion as straightforward as I can and explain it in minimal steps.

Before jumping into the minutiae of the topic, we must give a passing glance to the following terms:

Amortization – process of allocation of expense over the periods benefited.

Carrying Value – Face Amount of Debt + unamortized premium or discount + unamortized issue costs.

Cash Interest Paid –  Stated Rate of Interest * Face Value of the Instrument.

Discount – When an instrument (for e.g. bond) is issued for less than its face value, the difference between the face value (for e.g. $ 100) and the issue price (for e.g. $ 98) is called discount ($ 2.00). This happens when the market rate of interest is more than the stated rate on the instrument.

Effective Interest Method – Amortizing the discount or premium to interest expense so as to generate a constant rate of interest when applied to the amount of debt outstanding (Carrying Value) at the beginning of any period.

• Effective Interest Expense –  Carrying Value of the Instrument * Effective Interest Rate.

Face Value – The stated amount or the principal due on the maturity date.

Market rate – The current rate of interest obtainable for obligations issued under similar circumstances by an issuer of equivalent creditability. The market rate is considered as the Effective Rate.

Premium - When an instrument (for e.g. bond) is issued for more than its face value, the difference between the face value (for e.g. $ 100) and the issue price (for e.g. $ 102) is called premium ($ 2.00). This happens when the market rate of interest is less than the stated rate on the instrument.

Stated Rate – The interest rate written on the face of the instrument.

Note:- Premiums or discounts on instruments held as a long term obligation must be amortized from the acquisition date to its maturity date. Authoritative Pronouncement, Codification Topic 835, Interest (formerly known as APB 21) specifies the usage of Interest Method for amortization of these differences.

At first, I contemplated this topic to be very puzzling. Nonetheless, I figured out that if the steps tabled below are followed religiously, one can sail through the questions in the exam without difficulty.

 • Start with identifying the face value, issue price, issue date, maturity date, stated interest rate and the market or effective interest rate of the instrument.

• Work out the premium or discount.

• Look for the timing of interest payments, i.e., is it being paid annually or semi-annually. If it is semi-annual reduce the stated and market rate to half and double the number of interest payments.

Compute the following and plug them in a tabular format for each period:

a. Cash interest paid = face value of the bond * stated rate of interest.

b. Interest expense = Carrying value at the beginning of the period * market rate of interest

c. Premium or discount amortized = Difference between amounts per step ‘a’ and ‘b’.

d. Unamortized Premium or discount = Total premium or discount less amount amortized in step ‘c’.

e. Carrying value = Face Value + unamortized premium or Face Value – unamortized discount.

Points to Ponder

• If the instrument is issued at a discount, cash interest paid will be less than interest expense and vice versa will hold true if the instrument is issued at a premium.

• When the bond is issued at a discount, in each period there will be an increase in interest expense and amount of discount amortized leading to an increase in carrying value of bond.

• When the bond is issued at a premium, in each period there will be a decrease in interest expense and increase in premium amortized leading to a decrease in carrying value of bond.

• Once the last interest payment period is reached, premium or discount gets completely amortized and the carrying value equals the face value of the bond as the unamortized amount is NIL.

• Unlike Straight Line method of interest amortization, under this method interest expense changes each period giving constant interest rate on the carrying value.

 I will continue with this topic in my next post and look at some of the journal entries both in the books of borrower and investor.
 
Until then good bye and take care.
 
Aprajita



4 comments:

  1. Is there any change in the method to calculate the amortization if the bond has principal amortization?
    consider the following cashflow
    Date Principal Interest
    31/12/2009 -10,000,000
    31/12/2010 500,000
    31/12/2011 1,000,000 500,000
    31/12/2012 2,000,000 450,000
    31/12/2013 3,000,000 350,000
    31/12/2014 4,000,000 200,000

    ReplyDelete
  2. Hi Aprajita,

    Thank you for writing such an informative and useful blog.

    The Effective Interest Method that you have posted also mentioned its application applies to Lease Obligations as well. Just wonder could you kindly provide me with more information regarding how the Effective Interest Method works in Lease Obligations (I understand how it works in bond situation), including how to perform the calculations and bookings. If possible, please kindly provide me with further reading references.

    Thank a lot!

    FH

    ReplyDelete
  3. Hi FH,

    Thanks for your inputs!!! I am glad that you found it useful.
    The effective interest menthod works in a similar fashion with lease obligations as explained above.
    To explain briefly, start with the carrying value at the inception of lease and back out the first instalment (assuming annuity due) and that should be your starting point to compute the interest expense from the second instalment.

    Hope this helps. Appreciate your visiting my blog!

    Aprajita

    ReplyDelete
  4. Hi Aprajita,

    Thanks for your reply!

    Your blog is not only useful & informative, but also motivated me to write my own blog in business valuation, which is my profession. I may have a lot to ask you in the future regarding how to creat this kind of blog.

    Please keep in touch and keep up with your good work. Well done!

    FH

    ReplyDelete