CHAPTER 6 – EFFECTIVE INTEREST METHOD

Introduction
PFRS 9 requires that discount on bonds payable,
premium on bonds payable and bond issue cost shall be Discount amortization
amortized using the effective interest method. Interest expense minus interest paid. Thus, for the
period January 1 to June 30, 2020, the discount
The effective interest method is also known as scientific
amortization is P48,227 minus P40,000 or P8,227.
method or simply "interest method".
This method distinguishes two kinds of interest rate, Carrying amount
namely the nominal rate and effective rate. Preceding carrying amount plus the discount
amortization. Thus, on June 30, 2020, the carrying
The nominal rate is the coupon or stated rate.
amount is P964,540 plus P8,227 or P972,767.
The effective rate is the yield or market rate.
The carrying amount is actually the amortized cost
The effective rate is the rate that exactly discounts contemplated in the standard.
estimated cash future payments through the expected
life of the bonds payable or when appropriate, a shorter Journal entries for 2020
period to the net carrying amount of the bonds payable. Jan. 1 Cash 964,540
Discount on bonds payable 35,460
When bonds are sold at face amount, the effective rate
Bonds payable 1,000,000
and the nominal rate are the same.
But when the bonds are sold at a discount or premium, June 30 Interest expense 48,227
the two rates differ. Cash 40,000
When bonds are sold at a premium, the effective rate is Discount on bonds payable 8,227
lower than the nominal rate.
Note that the payment of the semiannual interest and the
When the bonds are sold at a discount, the effective periodic amortization of the discount are compounded in one
rate is higher than the nominal rate. entry. The two items can be separately recorded.

Effective interest method Dec. 31 Interest expense 48,638

Under the effective interest method, the effective interest Cash 40,000
expense is determined by multiplying the effective rate Discount on bonds payable 8,638
by the carrying amount of the bonds.
The carrying amount of the bonds changes every year Effective amortization of premium
as the amount of premium or discount is amortized On January 1, 2020, an entity issued three-year 12%
periodically. bonds with face amount of P1,000,000 for P1,049,740, a
The effective interest is then compared with the nominal price which will yield a 10% effective interest cost per
interest. The difference is the premium or discount year. The interest is payable annually every December
amortization. 31.

Thus, the premium amortization is computed as Schedule of amortization

follows: Date Interest Interest Premium Carrying
Nominal interest (nominal rate × face amount) xx paid expense amortization amount
Less: Effective interest (effective rate × carrying amount) xx Jan. 1, 2020 1,049,740
Premium amortization xx Dec. 31, 2020 120,000 104,974 15,026 1,034,714
Dec. 31, 2021 120,000 103,471 16,529 1,018,185
The discount amortization is computed as follows: Dec. 31, 2022 120,000 101,815 18,185 1,000,000
Effective interest xx
Less: Nominal interest xx
Discount amortization xx Interest paid – Face amount of P1,000,000 times the
annual nominal rate of 12% or P120,000.
Effective amortization of discount
On January 1, 2020, an entity issued two-year 8% bonds Interest expense – Carrying amount times the annual
with face amount of P1,000,000 for P964,540, a price effective rate. Thus, for 2020, the interest expense is
which will yield a 10% effective interest cost per year. P1,049,740 times 10% or P104,974.
Interest is payable semiannually on June 30 and
December 31. Premium amortization – Interest paid minus interest
expense. Thus, for 2020, the premium amortization is
Schedule of amortization P120,000 minus P104,974 or P15,026.
Date Interes Interest Discount Carrying
t paid expense amortization amount Carrying amount – Preceding carrying amount minus
Jan. 1, 2020 964,540
the premium amortization. Thus, on December 31, 2020,
Jun. 30, 2020 40,000 48,227 8,227 972,767
the carrying amount is P1,049,740 minus P15,026 or
Dec. 31, 2020 40,000 48,638 8,638 981,405
Jun. 30, 2021 40,000 49,070 9,070 990,475 P1,034,714.
Dec. 31, 2021 40,000 49,525 9,525 1,000,000
Journal entries for 2020
Interest paid Jan. 1 Cash 1,049,740
Face amount times semiannual nominal rate of 4% or Bonds payable 1,000,000
P40,000. Premium on bonds payable 49,740

Interest expense Dec. 31 Interest expense 104,974

Carrying amount times semiannual effective rate. Thus, Premium on bonds payable 15,026
for the period January 1 to June 30, 2020, the interest Cash 120,000
expense is P964,540 times 5% or P48,227.
Note again that the annual payment of interest and the
CHAPTER 6 – EFFECTIVE INTEREST METHOD

premium amortization are compounded in one entry. PV of an ordinary annuity of 1 at 5% for 6 periods 5.0757
Present value of principal (5,000,000 × .7462) 3,731,000
Present value of interest payments (300,000 × 5.0757) 1,522,710
Total present value 5,253,710

The semiannual interest payment of P300,000 is

computed by multiplying the face amount of P5,000,000
by the semiannual nominal rate of 6%.
Market price or issue price 5,253,710
Face amount 5,000,000
Market price or issue price of bond payable Premium on bonds payable 253,710
The market price or issue price of bond payable is equal Table of amortization
to the present value of the principal bond liability plus the Date Interest Interest Premium Carrying
present value of future interest payments using the paid expense amortization amount
effective or market rate of interest. Jan. 1, 2020 5,253,710
Jun. 30, 2020 300,000 262,686 37,314 5,216,396
In other words, the market price of bonds payable is Dec. 31, 2020 300,000 260,820 39,180 5,177,216
equal to the sum of the following: Jun. 30, 2021 300,000 258,861 41,139 5,136,077
a. Present value of bonds payable Dec. 31, 2021 300,000 256,804 43,196 5,092,881
Jun. 30, 2022 300,000 254,644 45,356 5,047,525
b. Present value of the total interest payments Dec. 31, 2022 300,000 252,475 47,525 5,000,000
The present value of the principal bond liability is equal
to the face amount of the bond multiplied by the present PV factor through ordinary calculator
value of 1 factor at the effective rate for a number of The PV of 1 at 5% for 6 periods and the PV of an
interest periods. ordinary annuity of 1 at 5% for 6 periods can be
determined through the use of an ordinary calculator.
The present value of the future interest payments is
equal to the periodic nominal interest multiplied by the Kindly get your calculator and try the following steps:
present value of an ordinary annuity of 1 factor at the 1. Enter 1.05
effective rate for a number of interest periods.
2. Press the division sign (÷) twice.
Illustration 1 3. Press the equal sign (=) for the number of interest
Face amount of bonds 4,000,000
Nominal rate 6% periods required. Press once for one period, press
Effective rate 8% twice for two periods and so on. In this case, press 6
times because there are 6 interest periods.
The bonds are issued on January 1, 2020 and mature in
four years on January 1, 2024. The interest is payable 4. The result is the PV of 1 at 5% for 6 periods
annually every December 31. or .7462.
Since the interest is payable annually, there are 4 5. Deduct 1.00 from the result in No. 4. The result
interest periods. The relevant present value factors are: is .2538 negative.
PV of 1 at 8% for 4 periods .7350 6. Press the plus/minus sign (+/-) to remove the
PV of an ordinary annuity of 1 at 8% for 4 periods 3.3121
negative in No. 5.
Computation of present value of the bonds 7. Divide the result in No. 6 by .05.
Present value of principal (4,000,000 × .7350) 2,940,000
Present value of annual interest payments 8. The result is the PV of an ordinary annuity of 1 at 5%
(240,000 × 3.3121) 794,904 for 6 periods or 5,0757.
Total present value 3,734,904
Illustration 3 – serial bonds
The annual interest payment of P240,000 is determined Face amount of bonds 3,000,000
by multiplying the face amount of P4,000,000 by the Nominal rate 12%
nominal rate of 6%. Effective rate 10%
Date of issue January 1, 2020
Face amount 4,000,000 Annual payment every December 31 1,000,000
Market price or issue price 3,734,904 Interest is payable annually December 31
Discount on bonds payable 265,096
Present value of 1 at 10%
Table of amortization One period 0.9091
Date Interest Interest Discount Carrying Two periods 0.8264
paid expense amortization amount Three periods 0.7513
Jan. 1, 2020 3,734,904
Dec. 31, 2020 240,000 298,792 58,792 3,793,696 Present value of bonds payable
Dec. 31, 2021 240,000 303,496 63,496 3,857,192 (a) (b) (a × b)
Dec. 31, 2022 240,000 308,575 68,575 3,925,767
Principal Interest Total PV Present
Dec. 31, 2023 240,000 314,233 74,233 4,000,000 payment payment payment factor value
Date
12/31/2020 1,000,000 360,000 1,360,000 .9091 1,236,376
Illustration 2 12/31/2021 1,000,000 240,000 1,240,000 .8264 1,024,736
Face amount of bonds 5,000,000 12/31/2022 1,000,000 120,000 1,120,000 .7513 841,456
Nominal rate 12% Total present value 3,102,568
Effective rate 10% Face amount 3,000,000
Premium on bonds payable 102,568
The bonds are issued on January 1, 2020 and mature in
three years on January 1, 2023. The interest is payable Interest payment
semiannually every June 30 December 31. December 31, 202 (3,000,000 3,000,000
Premium on bonds payable 102,568
Since the interest is payable semiannually, there are 6
interest periods The present value factors using the
Table of amortization
semiannual effective rate are: Interes Interest Premium Principal Carrying
t paid expens amortizatio payment amount
PV of 1 at 5% for 6 periods .7462 Date
e n
CHAPTER 6 – EFFECTIVE INTEREST METHOD

1/1/2020 3,102,56 On January 1, 2020, an entity issued three-year bonds

8
12/31/202 360,00 310,257 49,743 1,000,00 2,052,82 with face amount of P10,000,000 and 9% stated rate.
0 0 0 5
12/31/202 240,00 205,282 34,718 1,000,00 1,018,10 The bonds mature on January 1, 2023 and interest is
1 0 0 7 payable annually on December 31.
12/31/202 120,00 101,893 18,107 1,000,00
2 0 0 The bonds are issued at P9,751,210 with an effective
yield of 10% before considering the bond issue cost.
December 31, 2020
Interest paid (3,000,000 × 12%) 360,000 The entity paid bond issue cost of P239,880.
Interest expense (3,102,568 × 10%) 310,257 Face amount 10,000,000
Premium amortization for 2020 49,743 Discount on bonds payable (10,000,000 – 9,751,210) (248,790)
Carrying amount – January 1, 2020 3,102,568 Issue price 9,751,210
Premium amortization for 2020 (49,743) Bond issue cost (239,880)
Principal payment on December 31, 2020 (1,000,000) Net proceeds 9,511,330
Carrying amount – December 31, 2020 2,052,825

December 31, 2021

Interest paid (2,000,000 × 12%) 240,000
Interest expense (2,052,825 × 10%) 205,282 The effective rate is 10% but because of the bond issue
Premium amortization for 2021 34,718
cost, the effective rate must be higher than 10%.
Carrying amount – January 1, 2020 2,052,825
Premium amortization for 2021 (34,718) Thus, the problem is to find an effective rate that will
Principal payment on December 31, 2021 (1,000,000) equate the present value of the cash outflows for the
Carrying amount – December 31, 2021 1,018,107 bonds payable to the net proceeds of P9,511,330.

December 31, 2022 The cash outflows for the bonds payable include the
Interest paid (1,000,000 × 12%) 120,000 principal of P10,000,000 and the annual interest
Interest expense 101,983* payment of P900,000 for 3 years.
Premium amortization for 2022 18,107
The effective rate cannot be computed algebraically but
* 10% × P1,018,107 equals P101,811. There is a by means of trial and error or the interpolation process.
difference of P82 due to rounding of present value
The calculation of the effective rate requires the use of
factors.
mathematical table of present value of a single payment
and present value of an ordinary annuity.
Journal entries for 2020
1. Issuance of bonds: Again, the original effective rate is 10% but because of
Cash 3,102,568
the bond issue cost the new effective rate must be
higher than 10%.
Bonds payable 3,000,000
Premium on bonds payable 102,568 By interpolation and using an effective rate of 11%, the
present value of 1 for three periods is .7312.
2. Payment of interest:
The present value of an ordinary annuity of 1 for three
Interest expense 360,000 periods at 11% is 2.4437.
Cash 360,000
The present value of the bonds payable using an interest
3. Amortization of premium: rate of 11% is determined as follows:
Premium on bonds payable 49,743 PV or principal (10,000,000 × .7312) 7,312,000
PV of interest payments (900,000 × 2.4437) 2,199,330
Interest expense 49,743
Total present value 9,511,330
4. Payment of principal: Coincidentally, the present value of the bonds payable
Bonds payable 1,000,000 of P9,511,330 is the same as the net proceeds of
Cash 1,000,000 P9,511,330.
In conclusion, the new effective rate is 11%.
Effective interest method – bond issue cost
PFPS 9 provides that “transaction costs” that are directly Journal entries
attributable to the issue of a financial liability shall be 1. To record the issuance of the bonds:
included in the initial measurement of the financial Cash 9,511,330
liability. Discount on bonds payable 488,670
Transaction costs are defined as fees and Bonds payable 10,000,000
commissions paid to agents, advisers, brokers and
dealers, levies by regulatory agencies and securities Under the effective interest method, the bond issue
exchange, and transfer taxes and duties. Clearly, cost is added to the discount on bonds payable.
transaction costs include bond issue costs. 2. To record the annual interest payment:
The calculation of effective interest rate shall include all Interest expense (10,000,000 × 9%) 900,000
transaction costs, premiums and discounts. Cash 900,000
Thus, bond issue costs will increase discount on bonds
3. To record the amortization of the discount on bonds
payable and will decrease premium on bonds payable.
payable using the effective interest method:
Under the effective interest method, bond issue cost Interest expense 900,000
must be “lumped” with the discount on bonds payable Cash 900,000
and “netted” against the premium on bonds payable.
Interest expense (9,511,330 × 11%) 1,046,246
Illustration 1 – Discount and bond issue cost
CHAPTER 6 – EFFECTIVE INTEREST METHOD

Interest expense (10,000,000 × 9%) 900,000 X −11 %

Amortization of discount on bonds payable 146,246
12%−11 %
Financial calculator The present value applicable to the rates are then
Actually, the effective rate can easily be determined substituted as follows:
through the use of a financial calculator. In practice, this 9,300,000−9,630,900
is usually the case.
9,278,800−9,630,900
1. Enter negative P10,000,000 (cash outflow for
principal), press FV 330,900
=.94
2. Enter negative P900,000 (cash outflow for interest), 352,100
press PMT
3. Enter 3 (maturity), press N This differential of .94 between 11% and 12% is added
4. Enter positive P9,511,330 (net proceeds), press PV to 11% to get an effective rate of 11.94%.
5. Press comp (compute) and i% (effective rate)
6. Press EXE (execute) Financial calculator
7. The financial calculator will yield an answer of 11% 1. Enter negative P10,000,000 (cash outflow for
principal), press FV
2. Enter negative P1,000,000 (cash outflow for
interest), press PMT
3. Enter 5 (maturity), press N
4. Enter positive P9,300,000, press PV
Illustration 2 – Discount and bond issue cost 5. Press comp (compute) and i% (effective rate)
On January 1, 2020, an entity issued 5-year bonds with 6. Press EXE (Execute)
face amount of P10,000,000 at 95. 7. The financial calculator will yield an answer of
11.94%
The nominal rate is 10% and the interest is payable Illustration 3 – Premium and bond issue cost
annually on December 31. On January 1, 2020, an entity issued 5-year bonds with
The bonds mature on January 1, 2025. The entity paid face amount of P10,000,000 at 105. The nominal rate is
bond issue cost of P200,000. 10% and the interest is payable annually on December
31.
Face amount 10,000,000
Discount on bonds payable (500,000) The bonds mature on January 1, 2025. The entity paid
Issue price (10,000,000 × 95%) 9,500,000 bond issue cost of P200,000.
Bond issue cost (200,000)
Net proceeds 9,300,000 Face amount 10,000,000
Premium on bonds payable 500,000
Again, the problem is to find an effective rate applicable Issue price (10,000,000 × 105%) 10,500,000
to the net proceeds of P9,300,000. Bond issue cost (200,000)
Net proceeds 10,300,000
Since the bonds are issued at a discount, the effective
Cash 10,300,000
rate must be higher than the nominal rate of 10%.
Bonds payable 10,000,000
By interpolation, using a rate of 11%, the present value Premium on bonds payable 300,000
of 1 for 5 periods is .5935.
Under the effective interest method, the bond issue cost
The present value of an ordinary annuity of 1 for 5
is “netted” against the premium on bonds payable.
periods at 11% is 3.6959.
PV or principal (10,000,000 × .5935) 5,935,000 Since the bonds are issued at a premium, the effective
PV of interest payments (1,000,000 × 3.6959) 3,695,900 rate must be lower than 10%.
Total present value 9,630,900
By interpolation, using a rate of 9%, the present value of
The net proceeds of P9,300,000 are lower than the 1 for 5 periods is .6499 and the present value of an
present value of the bonds payable of P9,630,900 using ordinary annuity of 1 is 3.8897.
11% interest rate. PV or principal (10,000,000 × .6499) 6,499,000
This means that the effective rate must be higher than PV of interest payments (1,000,000 × 3.8897) 3,889,700
Total present value 10,388,700
11%.
The net proceeds of P10,300,000 are lower than the
So another interpolation is made using another rate of
present value of the bonds payable of P10,388,700
12%.
using a 9% interest rate.
The present value of 1 for 5 periods at 12% is .5674. The
This means that the effective rate must be higher than
present value of an ordinary annuity of 1 for 5 periods at
9%.
12% is 3.6048.
PV or principal (10,000,000 × .5674) 5,674,000 In conclusion, the effective rate must be between 9%
PV of interest payments (1,000,000 × 3.6048) 3,604,800 and 10%.
Total present value 9,278,800

The net proceeds of P9,300,000 are higher than the The differential rate between 9% and 10% is interpolated
present value of the bonds payable of P9,278,800 using as follows (Let X as the unknown effective rate):
12% interest rate. This means that the effective rate X−9 %
must be lower than 12%.
10 %−9 %
In conclusion, the effective rate must be between 11%
Substituting the present values applicable to the
and 12%.
corresponding rate:
With this scenario, the differential between 11% and
12% is interpolated as follows (Let X as the unknown 10,300,000−10,388,700
effective rate): 10,000,000−10,388,700
CHAPTER 6 – EFFECTIVE INTEREST METHOD

88,700
=.23
388,700
Thus, the effective rate is 9.23% (9% plus .23).

Financial calculator
1. Enter negative P10,000,000 (principal) and press
FV.
2. Enter negative P1,000,000 (annual interest) and
press PMT.
3. Enter 5 (maturity) and press N.
4. Enter positive P10,300,000 (net proceeds) and press
PV.
5. Press comp (compute) and i% (effective rate)
6. Press EXE (execute)
7. The financial calculator will yield an answer of
9.23%.