EFFECTIVE

INTEREST
METHOD
CHAPTER 6
PFRS 9 requires that discount on bonds payable,
premium on bonds payable and bond issue cost
shall be amortized using effective interest
method.
The effective Interest Method is also known as
scientific method or simply “interest method”.
The method distinguishes two kinds of interest
rate, namely the nominal rate and effective rate.
The nominal rate is the coupon or stated
rate.
The effective rate is the yield or market rate.

The effective rate is the rate that exactly

discounts estimated cash future payments
through the expected life of the bonds payable or
when appropriate, a shorter period to the net
carrying amount of the bonds payable.
When bonds are sold at face amount, the
effective rate and the nominal rate is the
same.
But when the bonds are sold at a discount or
premium, the two rates differ.
When bonds are sold at a premium, the
effective rate is lower than the nominal rate.
When the bonds are sold at a discount, the
effective rate is higher than the nominal rate.
 Effective Interest Method
Under the effective interest method, the effective
interest expense is determined by multiplying the
effective rate by the carrying amount of the
bonds.
The carrying amount of the bonds changes every
year as the amount of premium or discount is
amortized periodically.
The effective interest is then compared with the
nominal interest. The difference is the premium or
discount amortization.
Thus, the premium amortization is computed as follows:
Nominal interest (nominal rate x face amount) xx
Less: Effective interest (effective rate x carrying amount) xx
Premium amortization xx

The discount amortization is computed as follows:

Effective interest xx
Less: Nominal interest xx
Discount amortization xx
Effective amortization of discount
On January 1, 220, an entity issued two-year 8% bonds with face
amount of ₱1,000,000 for ₱964,540, a price which will yield a 10%
effective interest cost per year. Interest is payable semiannually on
June 30 and December 31.
Schedule of Amortization
Interest Discount Carrying
Date Interest Paid Expense Amortization Amount
Jan. 1, 2020 964,540
June 30, 2020 40,000 48,227 8,227 972,767
Dec. 31, 2020 40,000 48,638 8,638 981,405
June 30, 2021 40,000 49,070 9,070 990,475
Dec. 31, 2021 40,000 49,525 9,525 1,000,000
• Interest paid
Face amount times semiannual nominal rate of 4% or ₱40,000.
• Interest expense
Carrying amount time semiannual effective rate. Thus, for the
period January 1 to June 30, 2020, the interest expense is ₱964,540
times 5% or ₱48,227.
• Discount amortization
Interest expense minus interest paid. Thus, for the period
January 1 to June 30, 2020, the discount amortization is ₱48,227
minus ₱40,000 or ₱8,227.
• Carrying amount
Preceding carrying amount plus discount amortization. Thus,
on June 30, 2020, the carrying amount is ₱964,540 plus ₱8,227
or ₱972,767.
The carrying amount is actually the amortized cost
contemplated in the standard.
Journal Entries for 2020
Jan. 1 Cash 964,540
Discount on bonds payable 35,460
Bonds Payable 1,000,000

June 30 Interest expense 48,227

Cash 40,000
Discount on bonds payable 8,227

Note that the payment of the semiannual interest and the periodic amortization
of the discount are compounded in one entry. The two items can be
separately recorded.
Dec. 31 Interest expense 48,638
Cash 40,000
Discount on bonds payable 8,638
Effective amortization of premium
On January 1, 2020, an entity issued three-year 12% bonds with
face amount of ₱1,000,000 for ₱1,049,740, a price which will yield
a 10% effective interest cost per year. The interest is payable
annually every December 31.

Schedule of amortization

Date Interest Paid Interest Expense Discount Amortization Carrying Amount

Jan. 1, 2020 1,049,740

Dec. 31,
2020 120,000 104,974 15,026 1,034,714
Dec. 31,
2021 120,000 103,471 16,529 1,018,185
Dec. 31,
2022 120,000 101,815 18,185 1,000,000
• Interest paid
Face amount of ₱1,000,000 times the annual nominal rate of
12% or ₱120,000.
• Interest expense
Carrying amount times annual effective rate. Thus, for 2020, the
interest expense is ₱1,049,740 times 10% or ₱104,974.
• Discount amortization
Interest paid minus interest expense. Thus, for 2020, the
premium amortization is ₱120,000 minus ₱104,974 or ₱15,026.
• Carrying amount
Preceding carrying amount minus the premium amortization.
Thus, on December 31, 2020, the carrying amount is ₱1,049,740
minus ₱15,026 or ₱1,034,714.
Journal Entries for 2020
Jan. 1 Cash 1,049,740
Bonds Payable 1,000,000
Premium on bonds payable 49,740

Dec. 31 Interest expense 104,974

Premium on bonds payable 15,026
Cash 120,000

Note again that the annual payment of interest and the premium
amortization are compounded in one entry.
Market price or issue price of bond
payable
The market price or issue price of bond payable is equal to the
present value of the principal bond liability plus the present
value of future interest payments using the effective or market
rate of interest.

In other words, the market price of bonds payable is equal to the

sum of the following:
a. Present value of bonds payable
b. Present value of the total interest payments
The present value of the principal bond liability is
equal to the face amount of the bond multiplied
by the present value of 1 factor at the effective
rate for a number of interest periods.

The present value of the future interest payments

is equal to the periodic nominal interest
multiplied by the present value of an ordinary
annuity of 1 factor at the effective rate for a
number of interest periods.
ILLUSTRATION 1
Face amount of bonds 4,000,000
Nominal Rate 6%
Effective Rate 8%

The bonds are issued on January 1, 2020 and mature in four years on
January 1, 2024. The interest is payable annually every December 31.

Since, the interest is payable annually, there are 4 interest periods.

The relevant present factors are:

PV of 1 at 8% for 4 periods .7350

PV of an ordinary annuity of 1 at 6% for 4 periods 3.3121
 Computation of present value of the bonds
Present value of principal (4,000,000x.7350) 2,940,000
Present value of annual interest payments
(240,000x3.3121) 794,904
Total present value 3,734,904

The annual interest payment of ₱240,000 is determined by

multiplying the face amount of ₱4,000,000 by the nominal rate of
6%.
Face amount 4,000,000
Market price or issue price 3,734,904
Discount on bonds payable 265,096
Table of amortization
Interest Interest Discount Carrying
Date paid expense amortization amount
Jan. 1, 2020 3,734,904

Dec. 31, 2020 240,000 298,792 58,792 3,793,696

Dec. 31, 2021 240,000 303,496 63,496 3,857,192

Dec. 31, 2022 240,000 308,575 68,575 3,925,767

Dec. 31, 2023 240,000 314,233 74,233 4,000,000

ILLUSTRATION 2
Face amount of bonds 5,000,000
Nominal Rate 12%
Effective Rate 10%

The bonds are issued on January 1, 2020 and mature in three years on
January 1, 2023. The interest is payable semiannually every June 30 and
December 31.

Since, the interest is payable semiannually, there are 6 interest periods.

The present value factors using the semiannual effective rate are:

PV of 1 at 5% for 6 periods .7462

PV of an ordinary annuity of 1 at 5% for 6 periods 5.0757
Present value of principal (5,000,000x .7462) 3,731,000
Present value of annual interest payments
(300,000x 5.0757) 1,522,710
Total present value 5,253,710

The semiannual interest payment of ₱3000,000 is computed by

multiplying the face amount of ₱5,000,000 by the nominal rate of
6%.
Market price or issue price 5,253,710
Face amount 5,000,000
Premium on bonds payable 253,710
Table of amortization
Interest Discount
Date Interest paid expense amortization Carrying amount

Jan. 1, 2020 5,253,710

June 30, 2020 300,000 262,686 37,315 5,216,396

Dec. 31, 2020 300,000 260,820 39,180 5,177,216

June 30, 2021 300,000 258,861 41,139 5,136,077

Dec. 31, 2021 300,000 256,804 43,196 5,092,881

June 30, 2022 300,000 254,644 45,356 5,047,525

Dec. 31, 2022 300,000 252,475 47,525 5,000,000

PV factor through ordinary calculator
The PV of 1 at 5% for 6 periods and the PV of an ordinary annuity
of 1 at 5% for 6 periods can be determined through the use of an
ordinary calculator.
Kindly get your calculator and try the following steps:
1. Enter 1.05.
2. Press the division signs (÷) twice.
3. Press the equal sign (=) for the number of interest periods
required. Press once for one period, press twice for two
periods and so on. In this case, press 6 times because there are
6 interest periods.
4. The results is the PV of 1 at 5% for 6 periods or .7462.
5. Deduct 1.00 from the result in No. 4. the result
is .2538.
6. Press the plus/minus sign (+/-) to remove the
negative in No. 5.
7. Divide the result in No. 6 by .05.
8. The result is the PV of an ordinary annuity of 1 at 5%
for 6 periods or 5.0757.
ILLUSTRATION 3-serial bonds
Face amount of bonds 3,000,000
Nominal Rate 12%
Effective Rate 10%
Annual payment every December 31 January 1, 2020
Interest is payable annually December 31

PV of 1 at 10%
One period .9091
Two periods .8264
Three periods .7513
Present Value of the Bonds Payable

Principal Interest Total Present Value

Date Payment Payment Payment (a) PV Factor (b) (a x b)
Dec. 31, 2020 1,000,000 360,000 1,360,000 0.9091 1,236,376

Dec. 31, 2021 1,000,000 240,000 1,240,000 0.8264 1,024,736

Dec. 31, 2022 1,000,000 120,000 1,120,000 0.7513 841,456

Total Present Value       3,102,568

Face Amount       3,000,000

Premium on bonds payable       102,568

Interest Payment
December 31, 2020 (3,000,000 x 12%) 360,000
December 31, 2021 (2,000,000 x 12%) 240,000
December 31, 2022 (1,000,000 x 12%) 120,000

Present Value of the Bonds Payable

Interest Premium Principal Carrying

Date Interest paid expense amortization Payment amount
Jan. 1, 2020         3,102,568
Dec. 31, 2020 360,000 310,257 49,743 1,000,000 2,052,825
Dec. 31, 2021 240,000 205,282 34,718 1,000,000 1,018,107
Dec. 31, 2022 120,000 101,893 18,107 1,000,000 0
December 31, 2020
Interest Paid (3,000,000 x 12%) 360,000
Interest expense (3,102,568 x 10%) 310,257
Premium amortization for 2020 49,743

Carrying amount-January 1, 2020 3,102,568

Premium amortization for 2020 ( 49,743)
Principal payment on December 31, 2020 (1,000,000)
Carrying amount-December 31, 2020 2,052,825
December 31, 2021
Interest Paid (2,000,000 x 12%) 240,000
Interest expense (2,052,825 x 10%) 205,282
Premium amortization for 2021 34,718

Carrying amount-January 1, 2020 2,052,825

Premium amortization for 2021 ( 34,718)
Principal payment on December 31, 2021 (1,000,000)
Carrying amount-December 31, 2021 1,018,107
December 31, 2022
Interest Paid (1,000,000 x 12%) 120,000
Interest expense 101,893
Premium amortization for 2022 18,107

Journal Entries

1. Issuance of bonds:
Cash 3,102,568
Bonds payable 3,000,000
Premium on bonds payable 102,568
2. Payment of Interest
Interest expense 360,000
Cash 360,000
3. Amortization of premium:
Premium on bonds payable 49,743
Interest expense 49,743
4. Payment of Principal:
Bonds Payable 1,000,000
Cash 1,000,000
 Effective interest method-Bond Issue
Cost
PFRS 9 provides that “transaction costs” that are directly
attributable to the issue of a financial liability shall be
included in the initial measurement of the financial
liability.

Transaction costs are defined as fees and commissions

paid to agents, advisers, brokers and dealers, levies by
regulatory agencies and securities exchange, and transfer
taxes and duties. Clearly, transaction costs include bond
issue costs.
The calculation of effective interest rate shall
include all transaction costs, premiums and
discounts.

Thus, bond issue costs will increase discount on

bonds payable and will decrease premium on
bonds payable.

Under the effective interest method, bond issue

cost must be “lumped” with the discount on bonds
payable and “netted” against the premium on
bonds payable.
Illustration 1-Discount and Bond issue cost
On January 1, 2020, an entity issued three-year bonds with face
amount of ₱10,000,000 and 9% stated rate.
The bonds mature on January 1, 2023 and interest is payable annually
on December 31.
The bonds are issued at ₱9,751,210 with an effective yield of 10%
before considering the bond issue cost.
The entity paid bond issue cost of ₱239,880.
Face amount 10,000,000
Discount on bonds payable (248,790)
Issue price 9,751,910
Bond Issue cost (239,880)
Net Proceeds 9,511,330
The effective rate is 10% but because of the bond issue
cost, the effective rate must be higher than 10%.
Thus, the problem is to find an effective rate that will
equate the present value of the Cash outflows for the
bonds payable to the net proceeds of ₱9,511,330.
The cash outflows for the bonds payable include the
principal of ₱10,000,000 and the annual interest
payment of ₱900,000 for 3 years.
The effective rate cannot be computed algebraically but
by means of trial and error of the interpolation process.
The calculation of the effective rate requires the use
mathematical table of present value of a single payment
and present value of an ordinary annuity.

Again, the original effective rate is 10% but because of the

bond issue cost the now effective rate must be higher
than 10%.

By interpolation and using an effective rate of 11%, the

present value of 1 for three periods is .7312.
The present value of an ordinary annuity of 1 for three
periods
at 11% is 2.4437.
The present value of the bonds payable using an interest rate of
11% is determined as follows:
PV of principal (10,000,000 x .7312) 7,312,000
PV of interest payment ( 900,000 x 2.4437) 2,199,330
Total present value 9,511,330
Coincidentally, the present value of the bonds payable of
₱9,511,330 is the same as the net proceeds of ₱9,511,330
In conclusion, the new effective rate is 11%.
Journal entries
1. To record the issuance of the bonds
Cash 9,511,330
Discount on bonds payable 488,670
Bonds payable 10,000,000
Under the effective interest method, the bond issue cost is added to the discount on
bonds payable.
2. To record the annual interest payment:
Interest expense (10,000,000 x 9%) 900,000
Cash 900,000
3. To record the amortization of the discount on bonds payable using the
effective interest method:
Interest expense 146,246
Discount on bonds payable 146,246

Interest expense (9511330 x 1%) 1,046,246

Interest paid (10,000,000 x 9%) ( 900,000)
Amortization of discount on bonds payable 146,246
Financial Calculator
Actually, the effective rate can easily be determined through the use of a
financial calculator. In practice, this is usually the case.

1. Enter negative ₱10,000,000 cash outflow for principal, press TV

2. Enter negative ₱900,000 (cash outflow for interest), press PMT
3. Enter 3 (maturity), press N
4. Enter positive ₱9,511,330 (net proceeds), press PV
5. Press comp (compute) and i% (effective rate)
6. Press EXE (execute)
7. The financial calculator will yield an answer of 11%.
Illustration 2-Discount and Bond issue cost
On January 1, 2020, an entity issued year bonds with face amount of
₱10,000,000 at 95.
The nominal rate is 10% and the interest is payable annually on
December 31.
The bonds mature on January 1, 2026. The entity paid bond issue cost
of P200,000.

Face amount 10,000,000

Discount on bonds payable (500,000)
Issue price 9,500,000
Bond Issue cost (200,000)
Net Proceeds 9,300,000
Again, the problem is to find an effective rate applicable to the net
proceeds of ₱9,300,000 .
Since the bonds are issued at a discount, the effective rate must
be higher than the nominal rate of 10%.
By interpolation, using a rate of 11%, the present value of 1 for 5
periods is .5935.
The present value of an ordinary annuity of 1 for 5 periods at 11%
is 3.6959.
PV of principal (10,000,000 x .5935) 5,935,000
PV of interest payments (1,000,000 x 3.6959) 3,695,900
Total Present Value 9,630,900
The net proceeds of ₱9,300,000 are lower than the present value of
the bonds payable of ₱ 9,630,900 using 11% interest rate.

This means that the effective rate must be higher than 11%.

So another interpolation is made using another rate of 12%.

The present value of 1 for 5 periods at 12% is .5674. The present value
of an ordinary annuity of 1 for 5 periods at 12% is 3.6048.
PV of principal (10,000,000 x .5674) 5,671,000
PV of interest payments (1,000,000 x 3.6048) 3,604,800
Total Present Value 9,278,800
The net proceeds of ₱9,300,000 are higher than the present value of
the bonds payable of ₱ 9,278,800 using 12% interest rate. This
means that the effective rate must be lower than 12%.

In conclusion, the effective rate must be between 11% and 12%.

With this scenario, the differential between 11% and 12% in

interpolated as follows (Let X as the unknown effective rate):
X - 11%
12%-12%
The present values applicable to the rates are then substituted as
follows:
9,300,000-9,630,000
9,278,800-9,630,900
330,900 = .94
352,100
This differential of .94 between 11% and 12% is added to 11% to
get an effective rate of 11.94%.
Financial Calculator
1. Enter negative ₱10,000,000 (cash outflow for principal), press
FV
2. Enter negative ₱1,000,000 (cash outflow for interest), press
PMT
3. Enter 5 (maturity), press N
4. Enter positive ₱9,300,000, press PV
5. Press comp (compute) and i% (effective rate)
6. Press EXE (Execute)
7. The financial calculator will yield an answer of 11.94%.
Illustration 3-Premium and Bond issue
cost
On January 1, 2020, an entity issued 5-year bonds with face
amount of ₱10,000,000 at 105. The nominal rate is 10% and the
interest is payable annually on December 31.
The bonds mature on January 1, 2025. The entity paid bond issue
cost of ₱200,000.

Face amount 10,000,000

Discount on bonds payable 500,000
Issue price 10,500,000
Bond Issue cost ( 200,000)
Net Proceeds 10,300,000
Cash 10,300,000
Bonds payable 10,000,000
Premium on bonds payable 300,000

Under the effective interest method, the bond issue cost

is “netted” against the premium on bonds payable.
Since the bonds are issued at a premium, the effective
rate must be lower than 10%.
By interpolation, using a rate of 9%, the present
value of 1 for 5 periods is .6499 and the present
value of an ordinary annuity of 1 is 3.8897.
PV of principal (10,000,000 x .6499) 6,499,000
PV of interest payments (1,000,000 x 3.8897) 3,889,700
Total Present Value 10,388,700
The net proceeds of ₱10,300,000 are lower than the present
value of bonds payable of ₱10,388,700 using a 9% interest rate.
This means that the effective rate must be higher than 9%.
In conclusions, the effective rate must be between 9% and 10%.
The differential rate between 9% and 10% is interpolated as
follows (let x as the unknown effective rate):
x - 9%
10%-9%
Substituting the present values applicable to the corresponding
rate:
10,300,000-10,388,700
10,000,000-10,388,700
88,700
= .23
388,700
Thus, the effective rate is 9.23%
Financial Calculator
1. Enter negative ₱10,000,000 (principal), press FV
2. Enter negative ₱1,000,000 (annual interest), press PMT
3. Enter 5 (maturity), press N
4. Enter positive ₱10,300,000, 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%.
PROBLEM
S
Problem 6-1
Yellow Company received permission on January 1, 2020 to issue 12% bonds with
face amount of P6,000,000 maturing on January 1, 2030.
Interest is payable annually on December 31. the bonds are callable at 102 plus
accrued interest.
On January 1, 2020, the entity issued the bonds for P6,737,000 with an effective
yield of 10%.
The fiscal year of the entity ends December 31. The effective rate interest
amortization is used.
Required:
1. Prepare journal entries relating to the bonds payable for 2020.
2. Present the bonds payable on December 31, 2020.
Problem 6-1
Requirement 1

Jan. 1Cash 6,737,000

Bonds payable 6,000,000
Premium on bonds payable 737,000

Dec. 31Interest expense (6,000,000 x 12%) 720,000

Cash 720,000

31Premium on bonds payable 46,300

Interest expense 46,300

Interest paid 720,000

Interest expense (10% x 6,737,000) (673,700 )
Premuim amortization 46,300
Requirement 2

Noncurrent liabilities:
Bonds payable 6,000,000
Premium on bonds payable 690,700
Carrying amount 6,690,700
Problem 6-2
On January 1, 2020, Orange Company was authorized to issue 6%
bonds with face amount of ₱5,000,000 maturing on December 31,
2021. Interest is payable on June 30 and December 31.
On January 1, 2020, the entity issued all of the bonds for ₱4,818,500
with an effective rate of 8%.
The fiscal year of the entity is the calendar year and the effective
interest method of amortization is used.
Required:
1. Prepare a table of amortization for the discount.
2. Prepare journal entries for 2020 and 2021.
Problem 6-2

Requirement 1

Interest Interest Discount Carrying

Date paid expense amortization amount

Jan. 1, 2020 4,818,500

June 30, 2020 150,000 192,740 42,740 4,861,240

Dec. 31, 2020 150,000 194,450 44,450 4,905,690

June 30, 2021 150,000 196,228 46,228 4,951,918

Dec. 31, 2021 150,000 198,082 48,082 5,000,000

Requirement 2
2020
Jan. 1 Cash 4,818,500
Discount on bonds payable 181,500
Bonds payable 5,000,000

June 30 Interest expense 192,740

Cash 150,000
Discount on bonds payable 42,740

Dec. 31 Interest expense 194,450

Cash 150,000
Discount on bonds payable 44,450
 2021
June 30 Interest expense 196,228
Cash 150,000
Discount on bonds payable 46,228

Dec. 31 Interest expense 198,082

Cash 150,000
Discount on bonds payable 48,082

31Bonds payable 5,000,000

Cash 5,000,000
Problem 6-5
On December 31, 2020, Dome Company issued ₱4,000,000. 8%
serial bonds, to be repaid in the amount of ₱800,000 each year.
Interest is payable annually on December 31. the bonds were
issued to yield 10% a year.
The bond proceeds totaled ₱3,805,600 based on the present value
on December 31, 2020 of five annual payments.
Present Value on
Date Principal Interest 12/31/2020

12/31/2021 800,000 320,000 1,018,000

12/31/2022 800,000 256,000 872,200

12/31/2023 800,000 192,000 745,000

12/31/2024 800,000 128,000 633,800

12/31/2025 800,000 64,000 536,600
3,805,600
Problem 6-5
Requirement 1

Interest expense for 2021 (3,805,600 x 10%) 380,560

Interest paid for 2021 320,000
Discount Amortization 60,560

Bonds payable 4,000,000

Issue price-proseeds from issance (3,805,600 )
Discount on bonds payable-12/31/2020 194,400
Amortization for 2021 (60,560)
Discount on bonds payable-12/31/2021 133,840

Bonds payable 4,000,000

Payment on 12/31/2021 (800,000 )
Bonds payable-12/31/2021 3,200,000
Discount on bonds payable (133,840 )
Carrying amount-12/31/2021 3,066,160
Requirement 2
1. Cash 3,805,600
Discount on bonds payable 194,400
Bonds payable 4,000,000

2. Interest expense 320,000

Cash 320,000

3. Interest expense 60,560

Discount on bonds payable 60,560

4. Bonds payable 800,000

Cash 800,000