Chapter 20

EFFECTIVE INTEREST METHOD

Amortized cost, FVOCI and FVPL
Intermediate Accounting 1 (INVESTMENTS)
OBJECTIVES
 To apply the effective interest method of amortizing
bond discount and premium.
 To apply the measurement of bond investment at fair
value through other comprehensive income.
 To apply the fair value option of measuring bond
investment
 To be able to determine the market price of bonds.
INTRODUCTION
 PFRS 9 requires that bond discount and bond premium
shall be amortized using the effective interest method.
 Also known as scientific method or simply ‘interest
method’.
 Nominal rate is the coupon rate or stated rate appearing
on the face of the bond.
 Effective rate is the yield rate or market rate which is the
actual or true rate of interest which the bondholder
earns on the bond investment.
EFFECTIVE RATE VS NOMINAL
RATE
The effective and nominal rate are the same if
the cost of the bond investment is equal to the
face value.
If acquired at premium, effective rate is lower
than the nominal rate.
If acquired at discount, the effective rate is
higher than the nominal rate.
EFFECTIVE INTEREST METHOD

 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.
 Carrying amount of the bond investment is the initial cost
gradually increased by periodic amortization of discount
or gradually reduced by periodic amortization of
premium.
EFFECTIVE INTEREST METHOD - DISCOUNT
On January 1, 2019, an investor 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 December 31.
The cost of the bonds is P964,540, a price which will yield a 10% effective rate per
year.
1m*0.08/2 = 40,000
SCHEDULE OF AMORTIZATION 964,540*0.1/2 = 48,277

Date Interest Interest Discount Carrying

received income Amortization Amount
January 1, 2019 964,540
June 30, 2019 40,000 48,227 8,227 972,767
December 31, 2019 40,000 48,638 8,638 981,405
June 30, 2020 40,000 49,070 9,070 990,475
December 31, 2020 40,000 49,525 9,525 1,000,000
EFFECTIVE INTEREST METHOD - PREMIUM
On January 1, 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%. 1,000,000*0.12 = 120,000
1,049,740*0.10 = 104,974
SCHEDULE OF AMORTIZATION
Date Interest Interest Discount Carrying
received income Amortization Amount
January 1, 2019 1,049,740
December 31, 2019 120,000 104,974 15,026 1,034,714
December 31, 2020 120,000 103,471 16,529 1,018,185
December 31, 2021 120,000 101,815 18,185 1,000,000
EFFECTIVE INTEREST METHOD – SERIAL BONDS

Face amount of bonds 4,000,000

Acquisition cost 4,171,810
Premium on the bonds 171,810
Annual instalment on December 31,
2019 and every December 31,
thereafter 1,000,000
Date of issue January 1, 2019
Nominal interest rate payable 10%
annually every December 31
Effective interest rate 8%
SCHEDULE OF AMORTIZATION
Date Interest Interest Premium Principal Carrying
Received income amortization payment amount
1/1/2019 4,171,810
12/31/2019 400,000 333,745 66,255 1,000,000 3,105,555
12/31/2020 300,000 248,444 51,556 1,000,000 2,053,999
12/31/2021 200,000 164,320 35,680 1,000,000 1,018,319
12/31/2022 100,000 81,681 18,319 1,000,000 -
BOND INVESTMENT - FVTOCI
 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 are solely payments of principal interest on
the principal outstanding.
 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 profit or loss.
ILLUSTRATION

On January 1, 2019, an entity purchased bonds with face amount of

P5,000,000 for P4,760,000 including transaction cost P160,000. The business
model is to collect contractual cash flows and to sell the financial asset.
The bonds mature on December 31, 2021 and pay 10% interest annually on
December 31 with a 12% effective yield.
Financial asset – FVTOCI 4,760,000
Cash 4,760,000
Journal entry to record the annual interest received
Cash (10% x 5,000,000) 500,000
Interest income 500,000
AMORTIZATION OF DISCOUNT ON DECEMBER 31,2019
Financial asset – FVTOCI 71,200
Interest income 71,200

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
Continuation of the illustration
The market value of the bonds on December 31,2020 is 105 and the bonds are sold
on June 30, 2021 at 110 plus accrued interest.
Journal entries
1. To record the interest received:
Cash 500,000
Interest income 500,000
2. To record the discount amortization:
Financial asset – FVTOCI 79,744
Interest income 79,744
3. To record the change in market value:
Financial asset – FVTOCI 70,256
Unrealized gain – OCI 70,256

Market value – 12/31/20 (5,000,000 x 105) 5,250,000

Carrying amount per table – 12/31/20
(5,100,000 + 79,744) 5,179,744
Increase in unrealized gain 70,256
Journal entries for 2021
1. To record the discount amortization from January 1 to June 30, 2021:
Financial asset- FVTOCI 44,528
Interest income
(89,056 x ½) 44,528
2. To record the sale of the bonds on June 30, 2021:
Cash 5,750,000
Unrealized gain 339,056
Financial asset – FVTOCI 5,294,528
Gain on sale of financial asset 544,528
Interest income 250,000

Sale price (5,000,000 x 110) 5,500,000

Unrealized gain – OCI 339,056
Total 5,839,056
Investment balance per book – 06/30/21 5,294,528
Gain on sale of financial asset 544,528
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 FVTPL even if the financial asset satisfies
the amortized cost or FVTOCI measurement.
 All changes in fair value are recognized in profit or loss.
Accordingly, any transaction cost incurred is an outright
expense.
 Interest income is based on the nominal interest rate
rather than effective interest rate.
ILLUSTRATION

On January 1, 2019, an entity purchased bonds with face

amount of P5,000,000 for P5,400,000 plus broker commission
of P100,000.
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.
Journal entries for 2019

1. Financial asset – FVTPL 5,400,000

Commission expense 100,000
Cash 5,500,000
2. Cash (8% x 5,000,000) 400,000
Interest income 400,000
3. Financial asset – FVTPL 200,000
Gain from change in fair value
(5,600,000-5,400,000) 200,000
Market price of bonds

Market price of bonds is equal to the present

value of the principal plus the present value of
future interest payments using the effective rate.
 ILLUSTRATION 1 - DISCOUNT

Face amount of bonds 3,000,000

Date of issue of bonds January 1, 2019

Nominal rate 6%

Effective rate 8%

Interest payable annually December 31

Date of maturity December 31, 2021

The relevant present value of factors are:
PV of an ordinary annuity of 1 at 8% for three period 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
Effective interest rate is higher than the nominal interest rate. Thus, the
difference is a discount.
Face amount 3,000,000
Present value or market price of bonds 2,834,400
Discount 165,600
 ILLUSTRATION - PREMIUM

Face amount of bonds 3,000,000

Date of issue of bonds January 1, 2019

Nominal rate 8%

Effective rate 6%

Interest payable annually June 30 and December 31

Date of maturity December 31, 2020

The relevant present value of factors are:
PV of an ordinary annuity of 1 at 3% for four periods 3.72
PV of 1 at 3% for four periods 0.89

PV of principal (3,000,000 x .89) 2,370,000

PV of future interest payments (120,000 x 3.72) 446,400
Market price of bonds 3,116,400
Semiannual nominal interest payment
(4% x 3,000,000) 120,000
Effective interest rate is lower than the nominal interest rate. Thus, the
difference is a premium.
Face amount 3,000,000
Present value or market price of bonds 3,116,400
Premium 116,400
MARKET PRICE OF SERIAL BONDS
Face amount 6,000,000
Annual instalment every December 31 2,000,000
Date of issue January 1, 2019
Nominal interest rate payable
annually every December 31 12%
Effective interest rate 14%

Present Value of 1 at 14%

One period 0.8787
Two periods 0.770
Three periods 0.675
Principal due on December 31, 2019 2,000,000
Interest received on 12/31/2019 720,000
Total cash flows – December 31, 2019 2,720,000

Principal due on December 31, 2020 2,000,000

Interest received on 12/31/2020 (4,000,000 x 12%) 480,000
Total cash flows – December 31, 2020 2,480,000

Principal due on December 31, 2021 2,000,000

Interest received on 12/31/2021 (2,000,000 x 12%) 240,000
Total cash flows – December 31, 2021 2,240,000
The market price of the serial bonds is computed by multiplying the
total cash flows every December 31 by the relevant present value
factor.

December 31, 2019 (2,720,000 x .877) 2,385,440

December 31, 2020 (2,480,000 x .770) 1,909,600
December 31, 2021 (2,240,000 x .675) 1,512,000
Market price of serial bonds 5,807,040