Chapter 2.91® - Amortizing a Bond Premium Interest Expense – Straight Line Method & Effective Interest Method Example
The straight line method of amortization allocates interest expense equally over the life of the bonds (over the 4 annual interest payment periods). To calculate this number, we divide $54,090 by 4 giving us a total bond interest expense of $13,522.50 per period (year).
This entry is made on December 31st of each year for 4 years. The $1,477.50 debit to Premium on Bonds Payable reduces the carrying value of the bond payable because remember, bonds payable is a Credit account and any debit to it reduces its carrying value.
Effective Interest Method for Amortization of Bonds Payable
In the straight line amortization method, the bond’s carrying value changes each period while the bond interest expense each period remains the same. This displays a changing interest rate when the carrying value fluctuates each period while interest remains the same. Thus, the accounting handbooks advise to only use this rule when the results do not differ significantly from the effective interest method. The effective interest method allocates bond interest expense over the life of the bonds in such a way that it yields a constant rate of interest, which in turn is the market rate of interest at the date of issue of bonds. With effective interest method, the bond payable and discount/premium is calculated using the effective market interest rate versus the coupon rate used in straight-line method. Below is the amortization schedule for this bond issue using effective interest.
*Notice the $-63.52 of unamortized premium occurs due to rounding issues in these numbers but normally most companies would use automated amortization schedules that will take care of rounding issues leaving no variance.
The journal entry to record bond interest expense on December 31st, 2009 will be: