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

Effective Interest Method – Analysis and Example

In our article that discussed how costs incurred in the issuing of debt should be accounted for we used the effective interest method in our example. Today we are coming back to look at this method a bit more, giving a more detailed analysis and worked example of why this approach is used.

Background

When dealing with the issuing of financial instruments, in particular bonds, we are dealing with two interest rates. The first is the coupon rate, ie the rate that is being charged on the bond. And the second is the prevailing interest rates at the time. The difference between these two rates leads to premiums and discounts on a bond and so this needs to be reflected in the financial statements of the issuing party.

Where the bond is paying a higher interest rate than the prevailing market rate, for that bond’s risk rating, then the 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.

What the effective interest method provides us with is a more accurate means of reflecting these premiums or discounts at a particular point in time. This is instead of relying upon a straight-line method, which although simplier, does not reflect the true 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 are going to 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 bond is 5 per cent.

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 they were calculated:

  • 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.

We now bring ourselves to the journal entries required to bring this bond issue to account in ABC’s books and future year journal entries. Journal entry 1 below records the cash received, liability (debt) raised and the premium the new bond holders are willing pay for ABC’s is paying for this bonds. This provides a much 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 2 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 at 30 June for each year to reflect the borrowing costs and interest payment by ABC Ltd to bond holders.

Conclusion

We trust this article has helped in your understanding of how the effective interest method enables us to better reflect the actual borrowing cost for a firm. 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.

Leave a Reply

Your email address will not be published. Required fields are marked *