BATANGAS STATE UNIVERSITY

The National Engineering University

Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and
InternationalHospitality Management

INTERMEDIATE ACCOUNTING II
BS Management Accounting
1st Semester, AY 2024 – 2025

Reference: Conrado Valix, et.al

EFFECTIVE INTEREST METHOD

The effective interest 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 to the net carrying amount ofthe bonds payable.

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.

Under the effective interest method, the effective interest expense is determined by multiplying the
effective rate by the carrying amount of the bonds payable. The carrying amount of the bonds payable
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.

Premium amortization
Nominal interest (nominal rate x face Discount amortization
amount) Effective interest
Less: Effective interest (effective rate x Less: Nominal interest
carrying amount) Discount amortization
Premium amortization

Market price or issue price of bond payable

The market price or issue price of bonds 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:
Present value of bonds payable
Present value of the total interest payments

The present value of the principal bond liability is equal to the face amount of the bonds payable
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.

Effective interest method bond issue cost

IFRS 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.
ACC 309 Module 6 - Effective Interest Method
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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and
InternationalHospitality Management

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.

EXERCISES
1. On January 1, 2022, Marsh Company issued 10% bonds payable in the face amount of
6,000,000. The bonds mature on January 1, 2030. The bonds were issued for 5,316,000 to yield
12%, resulting in bond discount of 684,000.

The entity used the effective interest method of amortizing discount on bonds payable. Interest is
payable semi-annually on June 30 and December 31.

For the six months ended June 30, 2022, what amount should be reported as bond interest
expense?

2. On January 1, 2022, Ward Company issued 9% bonds with face amount 4,000,000which mature
on January 1, 2032. The bonds were issued for 3,756,000 to yield 10%, resulting in bond discount
of 244,000.

The entity used the interest method of amortizing bond discount. Interest is payable annually on
December 31.

On December 31, 2022, what amount should be reported as discount on bonds payable?

What is the carrying amount of bonds payable on December 31, 2022?

3. Webb Company had outstanding 7%, 10-year 5,000,000 face amount bonds. The bonds were
originally sold to yield 6% annual interest. The entity used the effective Interest method to
amortize bond premium.

On January 1, 2022, the carrying amount of the outstanding bonds payable was P5,250,000.

What amount should be reported as premium on bonds payable on December 31, 2022?

What is the carrying amount of bonds payable on December 31, 2022?

4. On January 1, 2022, Nixon Company reported 10% bonds payable with carrying amount of
ACC 309 Module 6 - Effective Interest Method
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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and
InternationalHospitality Management

P5,700,000. The bonds had a face amount of P6,000,000 and were issued to yield 12%.The
interest method of amortization is used. Interest was paid on January 1 and July 1 of each year.

On July 1, 2022, the entity retired the bonds payable at 102. The interest payment on July 1,
2022 was made as scheduled.

What is the carrying amount of the bonds payable on July 1, 2022?

What amount should be recorded as loss on the early extinguishment of the bonds payable?

MULTIPLE CHOICES
1. What is the interest rate written on the face of the bond?
a. Coupon rate
b. Nominal rate
c. Stated rate
d. Coupon rate, nominal rate or stated rate

2. What is the rate of interest actually incurred?

a. Market rate
b. Yield rate
c. Effective rate
d. Market, yield or effective rate

3. When the effective interest method is used, the periodic amortization would
a. Increase if the bonds were issued at a discount.
b. Decrease if the bonds were issued at a premium.
c. Increase if the bonds were ipsued at a premium.
d. Increase if the bonds were issued at either a discount or a premium.

4. When interest expense for the current year is more than interest paid, the bonds were issued at
a. A discount
b. A premium
c. Face amount
d. Cannot be determined

5. When interest expense for the current year is less thaninterest paid, the bonds were issued at
a. A discount
b. A premium
c. Face amount
d. Cannot be determined

ACC 309 Module 6 - Effective Interest Method

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