The effective interest method provides us with a better method to reflect the borrowing costs of the firm.

Effective Interest Method – Analysis and Example

Our previous article, costs incurred in issuing debt, used the effective interest method in its calculations. Today we are coming back to look at this method, giving a more detailed analysis of why we use this method and an example.

Background

When dealing with issuing financial instruments, in particular bonds, we are dealing with two interest rates. The first is the coupon rate, i.e. the bond’s interest rate. And the second is the prevailing interest rates at the time. The difference between the bond rates generates premiums and discounts, so we need to reflect this in the financial statements of the issuing party.

The bond is paying a higher interest rate than the prevailing market rate. For that bond’s risk rating, we would say the bond is trading at a premium. If, on the other hand, the bond is paying a lower rate than the prevailing interest rate, we are instead dealing with a bond discount.

The effective interest method provides us with a more accurate means of reflecting these premiums or discounts at a particular point in time, instead of relying upon a straight-line method, which, although simpler, does not reflect the actual borrowing costs of the firm.

Effective Interest Method Example and Journal Entries

In our example we used in our treatment of how to account for debt issuance costs, we ignored dealing with a discount or premium from issuing the instrument. This time we will look at a simple bond issuance by ABC Ltd, but it will be attracting a premium.

On June 30, 20XX, ABC Ltd issues a seven-year bond of $5,000,000 to the market at a coupon rate of 7 per cent, to be paid on an annual basis (to keep the calculations a bit simpler). The prevailing market rate for this grade and maturity of the bond is 5 per cent.

Calculations

In table 1 below, we set out the calculations that we need to bring the bond to account in ABC’s books.

Let’s have a look at each of the columns and see how you would calculate them:

  • Year: it is an annual payment of interest, so there are seven payments over seven years;
  • Annual Payment: this is the coupon interest payment. It is the par value of the bond multiplied by the the coupon rate. Each year this is $5,000,000 x 7% = $350,000;
  • Annual Interest: this is the prevailing bond interest rate multiplied by the Bond Book Value (see below). So for year 1 this is $5,578,637 x 5% = $278,932;
  • Premium Amortisation: the difference between the Annual Payment and the Annual Interest; in other words, in this case the above market rate being paid on the bond by ABC Ltd. In year 1 this is $350,000 – $278,932 = $71,068;
  • Unamortised Premium: the amount of premium to still be amortised by ABC at year end. So in year 0 this is the full difference between the present value of the bond and the issued par value: $5,578,637 – $5,000,000 = $578,637; and
  • Bond Book Value: this is the carrying present value of the bond on issue. At year 0 this is the full PV and from year 1 onwards it is the previous year’s balance less the Premium Amortisation for that year. For example in year 1 this is $5,578,637 – $71,068 = $5,507,569.

Journal Entries

We now bring ourselves to the journal entries for ABC’s books and future year journal entries. Journal entry one below records the cash received, liability (debt) raised and the premium the new bondholders are willing to pay for ABC’s is paying for these bonds. This provides a clearer picture to its financial statement readers of its debt position and subsequent borrowing costs.

DateAccount NameDebitCredit
30 JuneBank5,578,637
Bond Premium578,637
Debt5,000,000
Journal Entry 1

At the end of the first 12 months of the bond issue and ABC needs to account for interest payment and amortisation of the bond premium for the first year of issue. Journal entry two below provides the journal entries required:

DateAccount NameDebitCredit
30 JuneInterest Expense278,932
Bond Premium71,068
Bank350,000
Journal Entry 2

These journal entries would then be repeated on 30 June for each year to reflect the borrowing costs and interest payment by ABC Ltd to bondholders.

Conclusion

We trust this article has helped you understand how the effective interest method enables us to reflect the actual borrowing cost for a firm better. And the journal entries to bring these to account in the issuer’s books. As always, we welcome your feedback, comments below, or if you have a question, please use our Ask a Question page.

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