CHAPTER20

EFFECTIVE INTEREST. METHOD

Amortized
cost,'FVOCI and FVPL
t.

KNO
TECHNICAL WEDGE
To apply the effective interest niethod of amortizing bond
discount and premium.

ofbondinvestment
Toapplythemeasurement atfairvbiue
through other comprehensiveincome.

To apply the fair value option of measuring bond

investment.

To be able to determine the market price of bonds.

Introdtiction
PFRS 9 requires that bond discbunt and bond premium shall
be amortized using the effective interest method.

The effective interest method is also known as scientific

method or simply "interest method".

This method distinguishes two kinds of interest rate, namely

nominal rate and effective rate.
- x
.

The nominal rate is the coupon rate or stated rate

appearing on the face of the bond

rateistheyieldrateormarket
effective
.The 15
ratewhich
the actual or true rate of interest which the bondholder earns
on the bond investment.

The effective rate is the rate that exactly discounts

estimated future cash payments through the expected life
of the bond or when appropriate, a shorter period to the net
carrying amount of the bond.
Effective rate versus nominal rate
Theeffectiverate and the nominal rate are the same
' if
the
cost of the bond investment is equal to the face value.

Whenthe bonds are acquired at a premium, the effectiverate

is lower than the nominal rate.
p

The reasonis that the premium is a losson the part of the

bondholder.

On the other hand, when the bonds are acquired at a discount,

the effective rate is higher than the nominal rate.

The reason is that the discount 13 a gain on the part of the

bondholder. (. . t

in applying- .
Theeffectiverate andnominalrate arenecessary
the effective interest method.

Effective'interest method
_ i. , , ,
The effective interest method -simply requires the
comparison between the interest earned or interest income
* received.
and the interest

The difference between the two represents the premium or

discount amortization. .

Interest earned or interest income is computed by

multiplying the effective rate by the carrying amount of
the bond investment.

Interest received is computed by multiplying the nominal

rate by the face amount of the bond;

The carrying amount of the bond investment is the initial .

cost gradually increased by periodic amortization of discount
01 gradually reduced by periodic amortization of premium.
Effective interest method - Discount
On January 1, 2019, aninvestor acquired P1, 000, 000 face amount
bonds dated January 1, 2019 The bonds mature on December
31,2020.
The life of the bonds is 2 years and 8% interest is payable
semiannually on June 30 and December31.
The cost of the bonds is P964, 540, a price which will yield a
10% effective rate per year.

Schedule of amortization '

Interest Interest Discount Carrying
Date received income amortization amount

J an. 1, 2019 964.540

Jun. 30, 2019 40,000 48,227 8,227 972,767
Dec. 31, 2019 40,000 48,638 8,638 981.405
Jun. 30, 2020 40,000 49,070 9,070 990,475
Dec. 31, 2020 40,000 49,525 ' 9,525 1,000,000

Interest received.
faceamountof P1, nominalrateof
timessemiannual
4% or P40, 000. 000,000
Interest income .
effective
amounttimessemiannual
Cari'ying rate.
January1 to June30,2019,the interest
Thus,for the.period
incomeis P964,540 times 5% or P48,227.

"Discount amortization
Interest income minus interest received.

Thus, on June 30, 2019, the amortization is P48, 227 minus

P40, 000 or P8, 227.
-
3
Carrying amount .
carryingamountplusthe disobuntamortization.
Preoediné
Thus, on June 30, 2019, the carryingamount is P964,540 plus
P8,227DrP972,767.
 Journal entries

20 19

Jan, 1 Investment in b0nds

Cash 9645
40
964,540
Acquisition of the bonds.
Jun. 30 Cash 40,000
Interest income 40, 000
Sermannual interest received. -
Jun. 30 Investmentin bonds 8,227
Interest income 8,227
Amortization of discount for 6 months.

Dec; 31 Cash 40,000

Interest income 40,000

31 Investmentin bonds 8,688

Interest income 8,638 '
Amortization of discount for
the last 6 months. _

Note that the amortization is done on every interest date

, rather than at the end of the reportinglperiod.

2020

Jun. 30 Cash ' 40,000

Interest income . 40,000

30 Investmentinbonds 9,070
Interestincome , 9,070

Dec. 31 Cash
40.000
income
Interest 40,000
inbonds
. 31 Investment 9,525
Interest income
9,525
1 ,000 ,000
31Cash . 1,000,00
Invesmnentmbonds
collectionof faceamount
Full
 EEective interest method Premium
On J anuary l, 2019, an investor acquired P1, 000,000 face amount
bonds dated January 1, 2019. The bonds mature on December
31, 2021.
The bonds mature in 3 years and bear 12% interest payable
annually every December 31.
The cost of bonds is P1,049,740, a price which will yield an
effective interest of 10%.

Schedule of amortization

Interest Interest Premium Carrying

Date received income amortization amount

Jan. 1, 2019 1,049,740

Dec. 31, 2019 120,000 104,974 15,026 1,034,714
Dec. 31, 2020 120,000 103,471 16,529 1,018,185
Dec. 31, 2021 120,000 101,815 18,186 1,000,000

Interest received

Face amount of P1,000,000 times annual nominal rate of 12%

or P120,000.

Interest income

Carrying amount times annual effective rate.

Thus, for 2019, the interest income is P1,049,740 times 10% or
P 104,974. .,

Premigm amortization
Interest received minus interest income.

Thus, on December 31, 2019, the premium amortization is

P120,000 minus P104,974 or P15,026.

Carrying amount

Preceding carrying amount minus premium amortization.

Thus, on December 31, 2019, the carrying amount is P1,049,7 40
minus P15,026 or P1,034,7.14.
 Journal e ntlies

2019

Janl . InVBStmantin
C I bonds 1,049,740
1,049,740
M31 Cash
120,000
120,000
31 Interest income
15,026
Investmentin bonds
15,026

2020

Dec. 31 Cash '

120,000
Interest income 120,000
31 Interest income
16,529
Investment in bonds a 16,529

2021

Dec. 31 Cash 120,000

Interest income 120,000

31 Interest income 18, 185

Investment in bonds 18,185

31 Cash 1,000,000 '

Investment in bonds 1,000,000
Effectiveinterestmethod- Serialbonds
Face
amount
ofbonds ,0
2122
:23
Aoquisitionoost
Premiumonthebonds 17181 0
Annualinstallment
onDecember31,2019 1 000 000
andeveryDecember
31thereafter
Dateofissue January1,2019
Nominalinterest rate payable annually
0
December
every 31 1004
Effectiveinterestrate 8/°

Schedule of amortization
Date Interest Interest Premium Principa1 Carrying
received income amortization payment amo unt

1/1/2019 4.171.810
12/31/2019 400,000 333,745 66,255 1,000,000 3,105,555
12/31I2020 300,000 248,444 51,556 1,000,000 2,053,999
12I31/2021 200,000 164,320 35,680 1,000,000 1,018,319
12/31/2022 100,000 81,681 18,319 1,000,000

Interest received equals outstanding face amount times

nominal rate.

Thus, on December 31, 2019, P4,000,000 times 10% equals

P400,000, and on December 31, 2020, P3,000,000 times 10%
equals P300,000, and so on.
Interest income equals carrying amount times effective|
rate.

Thus, for 2019, P4,171,810 times 8% equals P333,7 45, and so -

on.

Premium amortization equals interest received minus

mterest mcome.

'
Thus, on December 31, 2019, P400,000
andsoon. mmus
P333745
equal
P66,255,
Cgrrying amount equals precedingcarrying amount minus
pnnclpal payment and_m1nus
premium amortization.
'
Thus, on December 31, 2019, P4,171:81Omlnus
minusP66,255
equals
P3,105,555. P1,000,0
 Journal entries

2019

Jan. 1 Inve stment in bonds 4,171,810

Cash 4,171,810

Dec31 Cash 1,400,000

I nvestment in bonds 1,000,000
Interest income 400,000

31 Interest income 66,255

Investment in bonds 66,255

2020

Dec.31 Cash 1,300,000

Investment in bonds 1,000,000
Interest income 300,000

31 Interest income 51,556.

Investment in bonds 51,556

202 1

Dec.31 Cash 1,200,000

Investment in bonds -
1,000,000
Interest income 200,000

31 Interest income 35,680

Investment in bonds 35,680

2022

Dec.31 Cash - 1,100,000

Investment in bonds 1,000,000
Interest income 100,000

31 Interest income 18,319

Investment in bonds 18,319
Bond investment - FVOCI

PFRS 9, paragraph 4.1.2A, provides that a financial asset

shall be measured at fair "value through other comprehensive
income if both of the following conditions are met:

a. The business model is'achieved both by collecting

contractual cash flows and by selling the financial
asset.

b. The contractual cash flows aresolely payments of

principal and interest on the principal outstanding.

Note that the business model includes selling the financial

asset in addition to collecting contractual cash flows.

In this case, interest income is recognized using the effective

interest method as in amortized cost measurement.

On derecognition, the cumulative gain or loss recognized in

other comprehensive income shall be reclassified to proth or
loss.
Illustration
On January 1: 2019 . an ' .
face
ent1ty purchased bonds Wlt h .
amalgitsgfomooqooo
cost
forP4,760,000 including transacmn
, 00- The business model is to collect contractual 603
flows and to sell the financial asset.
The bonds mature on December31, 2021and pay 10%interest
annually on December 31 with a 12% effective yield.
Financialasset ~FVOCI 4,760,000
Cash 4,760,000

Note that unhketrading transaction

bondinvestment; coet
1sIncluded m at fan:
the cost of financial asset
' measured
value through OCI.

J ournal entry to record the annhal interest received

Cash (10% 1:5,000,000) 500,000
'
Interest income 500,000

PFRS 9, paragraph 4.1.2A, mandates that interest income

for bond investment measured at fair value through other
comprehensive income must be calculated using the effective
interest method and included in profit or loss.

Accordingly, this would require amortization of any discount

or premium on the bond investment.

Face amount 5,000,000

Acquisition eost 4,760,000
Discount, 240,000

onDecember
0fdiscount
Amortization 31,2019
.
- FVOCI
asset
Financial 71,200
Interest income 7 1,200-

Date Interest Interest Discount Carrying

received income amortization amount
1/1/2019 4,760,000
12/31/2019 500,000 571,200 71,200 4,831,200
12/31/2020 500,000 579,744 79.744 4,910,944
12/31/2021 500.000 589.056 89,056 5,000,000
511
Explanation

Interes? received equalsface amount of P5.000,000 times

the nomlnal rate of 10% or P500,000.

IntereSt income equalscarrying amount times the effective

rate.

Thus, on December 31, 2019 P4,760,000 times 12% equals

P571,200 and so on.

Discount amortization equals interest income minus

interest recelved.

Thus, for 2019, P571,200 minus P500,000 equals P71,200 and

-
so on.

Carrying amount equals preceding carrying amount plus

discount amortization.

Thus, on Decembef31, 2019, P4,760,000 plus P71,200 equals

P4,831,200 and so on.

On December 31, 2019, the bond investment is measured at

fair value through other comprehensive inqome.

The bonds are quoted at 102 on December 31, 2019.

Market value December 31, 2019 (5,000,000 x 102%) 5,100,000

Carrying amount - December 3 1, 2019 4,83 1,200
'
Unrealized gain OCI _ 268,800

FinancialassetFVOCI 268,800
Unrealizedgain - OCI . 268,800

Subsequently, the entity must record discount amortization

of P7 9,7 44 for 2020 and P89,056 for 2021 in accordance with
the effective interest table of amortization regardless of the
change in market value.

The resulting carrying amount should then be adjusted to

conformwith the marketvalueon December31, 2020 and
2021. ° ,
 Continuation of the
illustration
Themarketvalueof thebondson
31,2020is 105
December
and the bonds are sold on June
interest. 30.2021 accrue
at110plus d

Journal entries for 2020

1. To record the interest received:

Cash
. . 500,000
Interest mcome 500,000
(10% X 5,000,000)

2. To record the discount amortiZation:

Financial asset FVOCI '

79,744
Interest income 79.744

3. To record the change in market value:

Financial
asset FVOCI 70,256
Unrealized gain OCI 70,256

Market value -December 31, 2020 (5,000,000 x 105) 5,250,000

Investment balance - December 31, 2020 '
(5, 100,000 + 79,744) 5,179,744
'
Increase in unrealized gain , _ 70,256

Another computation .

Market value December 31, 2020 5,250,000

Carrying amount per table December31, 2020
(seepreviouscomputation) 4,910,944
Cumulative unrealized gain - December 31, 2020 339,056
Unrealized gain - December 31, 2019 268,800
Increase in unrealized gain 70,256
 Journal entries for 2021
zation from January 1 t0
1. 5111101ti
To recordthe discount
June 30, 2021:
44,528
Financial asset FVOCI
Interest income 44,528
(89,066 x 1/2)

bondson J une 30, 2021:

2. To record the sale of the
000

Unrealizedgain- OCI 5 294 528

- FVOCI
Financialasset 544,528
Gainonsaleoffinancialasset I 250000
Interestincome .
' -
Sale 110)
(5,000,000x
price 5,333,9
gain- OCI
Unrealized £5§
-
Total 5,839,056
balanceper book«June30,2021
Investment . ,
(5,250,000+44,528) W
Gainonsaleoffinancial asset M

Another computation

Sale price . , 5,500,000

Carrying amount per table J une 30, 2021
'
(4,910,944 + 44,528) 4,955,472
5
Gainonsaleoffinancialasset 544,528
Saleprice 5,500,000
Interest accruedfromJanuary 1 to June 30, 2021
(5,000,000 x 10% x 1/2 > . 250,000
Totalcashreceived
5 750000

investment.
 Fair value option

PFRS 9, paragraph 4.1.5, provides that an entity at initial

recognition may irrevocably designate a financial asset as
measured at fair value through profit or 1093 even if the
financial asset satisfies the amortized cost or FVOCI
.
measurement.

In other words, investments in bonds can be designated

without; revocation as measured at fair value through profit
or loss even if the bonds are held for collection as a
business model.
\ I

Under the fair value option, all changes in fair value are
recognized in profit or loss. Accordingly, any transaction cost
incurred is an outright expense.

_Moreover, the interest income is based on the nominal

interest; rate rather than the effective interest rate.

Illustration
bondswithface.
OhJanuary1, 2019,anentitypurchased
amount of P5,000,000 for P5,400,000_..p1us
' '
broker commission
0fP100,000.

The stated interest rate is 8% payable annually every

December 31 with an effective rate of 6%. ,

On December 31, 2019, the bonds had a fair value of

P5,600,000.

. Johrnal entries for 2019

1. Financial asset - FVPL 5,400,000
Commission expense 100.000
Cash . 5,500,000

2. Cash (8% x 5,000,000) 400,000

Interest income '
400,000

31 Fipancialasset- FVPL ' 200,000

Gain from change in fair value 200,000
(5,600,000 - 5,400,000) 5

515 .
 Market price of bonds

to t he present value of t
The market Price 0f bonds equal
is
areInterest -
the value
prtncipalplus present of fut paymen
usmg the effective rate.

Illustration 1 Discount

Face
amount
ofbonds . J P3020000
Date of issueof bonds anuary 2019
Nominal
rate
EEective rate 3%
%
Interest
payable
annually . December
31
Date of maturity December 31, 2021

The presentvalueof an ordinary artnity 0f 1 is determined

for the number of interestperiods usmg the effectwerate.
Since the life of the bondsis three years and the ihterest is
payableannually, the numberof interest perlods 18three.
The relevant present valuleactors are:
PV of an ordinary annuity of 1 at 8% for three periods 2.58
PV of 1 at 8% for three periods 0.79
PV of principal (3,000,000 x .79) _ 2, 370,000
PV of future interest payments (180,000 x 2.58) 464,400
Market price of bonds 2,834,400

Annual nominal interest payment

(6% x 3,000,000) 180,000

The effective interest rate is higher than the nominal interest

rate. , , .

Thus, the difference between the face amount and present

valueis a dtscount.

Face amount 000

Pre
sent ormarket
value ofbonds
price 322240
Discount
165,600
M
 Illustration 2_ .
Premium
Face amount of bends
ofissue
Date 1333002323
,
rate
Nominal . January
8%
Effectiverate 6%
'mterESt
$331213
a my June 31
December
30and 3 2020
1,
December
anordinary
.of of
annuity 1is determined
or num
'flhetggesentbvalue
erOfmtereSt
Periods rate.
theeffective
using
life of the bondsis 2 yearsanathe interestis
Sinceblthe
paya e
semtannually, the number of interest periods is four.

annual
effeetive
is
rate 6%
orasemiannualof
effective
$580.
-
.
'

The relevant present value factors are:

'
'
of1 at 30/oforfour
PVofan ordinary annmt penods 3.72
of
PV 1at3%forfourperi30ds 0-89-
The hzarket price of bonds is equal to the present value of the
panCLpal plus the present value of future interest payments using
the effective rate.

PVofprinCipal (3,000,000 x .O.89) 2,670,000

PV of future interest payments (120,000 x 3.7 2) 446,400

Marketpriceofbonds 3,116,400
Semiannual nominal interest payment
(4% 1;3,000,000) 120,000

The effectiveinterest rate is bowerthan the nominal interest

rate. .

Thus, the differencebetweenthe face amount and present

value is a premium.

Faceamount . 3,000,000
valueormarketpnceofbonds
Present 3,116,400
Premium 1 116,400

A
Market price of eerial bonds
6,000,000
Faceamount 2300.000
Annual 31
everyDecember
installment January1,2019
Date of issue
interest
Nominal ratepayable every
annually 12%
December 31 14%
Effective interest rate

Present value of l at 14%

_
One penpd
' - 0.877
0770
Two pemods 0.675
Three periods

the
istocbmpute
Thesimpleapproach value
present 0fthe
cash flows from the bonds.
'
. . 2 000 000
Prmc1pal due on December 31, 2019 ,_
Interestreceivedbn12/ 311/ X12%)
2019(6,000,000 w
Totalcagh flows- December31,2019 ,1 W
Principaldue on December31, 2020 2,000,000
Interest received on 12 / 31 / 2020 (4,000,000 x 12%) 480,000
Totalcashfilows- December31,2020 2,480,000
'
Principaldue on December31, 2021 2,000,000
Interest received on 12 / 31 / 2021 (2,000,000 x 12%) 240, 000
Total cash flowsDecember 31, 2021 2, 240,000
The market price of the bonds is equal to the
present value of
theprincipal pleasthepresentvalueof future interestpayments
usmg the effectwe rate.

c0111puted by multl P1ymg

the total cash flows everyDeoember
valuefactor. 31 the by relevant
presen
December31,2019 (2,720,000 1:
Deoember31,2020 (2,480,0001:.877) 2,385,440
December31,2021 (2,240,000x .770) 1,909,600
.675)
ofserialbondg
Marketprice 1.512.000
5,807 .040
W.
M