# CHAPTER 5 : EFFECTIVE INTEREST METHOD

PFRS 9 requires that discount on bonds payable, premium on b/p and bond issue cost shall be amortized using the effective interest method. -also known as scientific method or ´interest methodµ -distinguishes two kinds of interest rate: the nominal rate and the effective rate Nominal rate ² the coupon or stated rate Effective rate ² the yield or market rate The effective rate is the rate that exactly discounts estimated cash future payments through the expected life of the b/p or when appropriate, a shorter period to the net carrying amount of the bonds payable. Date|Interest paid|Interest expense|Carrying amt. When bonds are sold at face value The effective rate and nominal rate are the same When bonds are sold at a discount or premium The two rates differ

Computation : Premium Amortization Nominal interest (nominal rate x face value) Less: Effective interest (effective rate x CA) Premium Amortization XX XX XX

Computation : Discount Amortization Effective interest Less : Nominal interest Discount amortization XX XX XX

Interest paid = face value x nominal rate Interest expense = CA x effective interest rate Discount amortization =interest expense ² interest paid Premium amortization = interest paid ² interest expense CA = preceding CA ² premium amort.

Carrying amount is actually the amortized cost contemplated in the standard.

MARKET PRICE OR ISSUE PRICE OF B/P Market price or issue price of b/p = present value of the principal bond liability + present value of future interest payments using the effective or market rate of interest Present value of the principal bond liability = face value of the bond x present value of 1 factor at the effective rate for a number of interest periods Present value of the future interest payments = periodic nominal interest x present value of an ordinary annuity of 1 factor at the effective rate for a number of interest periods Discount on bonds payable = Face value ² market price or issue price

When bonds are sold at a premium Nominal rate > Effective rate

When bonds are sold at a discount Effective rate > Nominal rate

EFFECTIVE INTEREST METHOD effective interest expense = effective rate X carrying amount of the bonds CA of the bonds changes every year as the amount of premium or discount is amortized periodically Effective interest is then compared with the nominal interest and the difference is the premium or discount amortization

4. Payment of principal Bonds payable Cash Effective interest method ² bond issue cost PFRS 9 ² ´transaction costsµ that are directly XX XX XX XX XX XX 2. brokers and dealers.00 from the result in no. advisers.7462 5. The result is the PV of an ordinary annuity of 1 at 5% for 6 periods or 5.Premium on bonds payable = market price or issue price of bonds ² face value PV Factor through ordinary calculator Ex. levies by regulatory agencies and securities exchange. Divide the result in No. Present value of bonds payable Date|Principal payment|Interest payment|total payment|PV factor|Present value Principal payment + interest payment = total payment Total payment x PV factor of 1 = present value Under the effective interest method.sign to remove the negative in no. Press the equal sign (=) for the number of interest periods required. premiums and discounts Bond issue costs will increase discount on bonds payable and will decrease premium on bonds payable.2538 6.05 Bonds payable Premium on bonds payable 2.0757 SERIAL BONDS Interest paid changes every year depending on the amount of bonds that mature per year (ex. Issuance of bonds: Cash XX equate the present value of the cash outflows for the bonds payable to the net proceeds. 5 7. Subtract 1M + interest payment from the face value and multiply it by the nominal interest rate to get the new interest paid for the next year) XX XX attributable to the issue of a financial liability shall be included in the initial measurement of the financial liability. The result is the PV of 1 at 5% for 6 periods or . Deduct 1. Include bond issue costs CALCULATION of effective interest rate ² shall include all transaction costs. Press the +/. Transaction costs ² fees and commissions paid to agents. Payment of interest: Interest expense Cash 3. Press the division sign twice 3. bond issue cost must be ´lumpedµ with the discount on bonds payable and ´nettedµ against the premium on bonds payable Net proceeds = Issue price ² bond issue cost THE PROBLEM is to find an effective rate that will ENTRIES: premium: 1. PV of 1 at 5% for 6 periods and the PV of an ordinary annuity of 1 at 5% for 6 periods 1. 4. The result is negative . 6 by .05 8. . and transfer taxes and duties. Enter 1. Amortization of premium: Premium on bonds payable Interest expense 4.

Annual interest payment Interest expense Cash 3. The calculation of the effective rate requires the use of mathematical table of present value of a single payment and present value of an ordinary annuity. the bond issue cost is ´nettedµ against the premium on bonds payable. Because of the bond issue cost. Issuance of the bonds Cash Bond discount & issue cost Bonds payable 2. Amortization of the bond discount and issue cost using the effective interest method Interest expense Bond discount & issue cost Interest expense ² interest paid = amortization of bond discount and issue cost Interest paid ² interest ex Effective rate between 11% and 12% Differential between 11% and 12% is interpolated as follows (Let X as the unknown effective rate): X ² 11% 12% . Effective rate can be computed by means of trial and error or ´interpolation processµ Premium and bond issue cost Cash Bonds payable Premium on bonds payable Under the effective interest method. the new effective rate must be higher (to get a lower present value) ENTRIES: 1.11% Substitute the present values applicable to the rates The differential between 11% and 12% is added to 11% to get the effective rate .