CHAPTER 8

EFFECTIVE INTEREST METHOD

Effective interest rate- 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.

- Bonds are sold at face amount when the effective rate and nominal rate are the same.

- When bonds are sold at a premium, the effective rate is lower than the nominal rate.

- When bonds are sold at a discount, the effective rate is higher than the nominal rate.

Formula of effective interest method:

Effective interest expense= effective rate x 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.
Formula of premium Amortization:
Nominal interest (Nominal rate x face amount) xx
Less: Effective interest (effective rate x carrying amount) xx
Premium amortization xx

Formula of Discount Amortization:

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

On January 1, 2019, an entity issued two-year 8% bonds with face amount of P1,
000,000 for P964, 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
Date Interest Paid Interest Discount Carrying
Expense Amortization Amount
Jan. 1, 2019 964,540
Jun. 30, 2019 40,000 48,227 8,227 972,767
Dec. 31, 2019 40,000 48,638 8638 981,405
Jun. 30, 2020 40,000 49,070 9070 990,4475
Dec. 31, 2020 40,000 49,525 9525 1,000,000
Interest Paid
Face amount x semiannual nominal rate of 4% or P40, 000.
Interest expense
Carrying amount x semiannual effective rate. Thus, for the period January 1 to June 30,
2019, the interest expense is P964, 540 x 5% or P 48, 227.
Discount Amortization
Interest expense minus interest paid. Thus, for the period January 1 to June 30, 2019,
the discount amortization is 48,227 minus 40,000 or P8, 227.
Carrying Amount
Preceding carrying amount plus the discount amortization. Thus on June 30, 2019, the
carrying amount is P 964, 540 plus P8227 or P927, 767.
The carrying amount is actually the amortized cost contemplated in the standard.
Journal entries for 2019
Jan. 1 Cash
Discount on bond payable
Bond payable
June 30 Interest expense
Cash
Discount on bonds payable
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
Cash
Discount on bonds payable

Effective Amortization of Premium

On January 1, 2019, an entity issued three-year 12% bonds with face amount of P1,
000,000 for P 1,049, 740, a price which will yield a 10% effective interest cost per year.
Interest is payable annually on June 30, and December 31.

Schedule of Amotization
Date Interest Paid Interest Discount Carrying
Expense Amortization Amount
Jan. 1, 2019 P 1,049, 740
Jun. 30, 2019 120,000 104,974 15,026 1,034,740
Dec. 31, 2019 120,000 103,471 16,529 1,018,185
Jun. 30, 2020 120,000 101,915 18,185 1,000,000

Interest Paid
Face amount x annual nominal rate of 12% or P120, 000.
Interest expense
Carrying amount x annual effective rate. Thus, for the period January 1 to June 30,
2019, the interest expense is P 1,049, 740 x 10% or P 104,974
Premium Amortization
Interest expense minus interest expense. Thus, for 2019, the premium amortization is
P120, 000 minus P104, 974 or P15, 026
Carrying Amount
Preceding carrying amount plus the discount amortization. Thus on December 31 2019,
the carrying amount is P 1, 049, 740 minus P 15,026 or P 1, 034, 714.
Journal entries for 2019
Jan. 1 Cash
Bond payable
Premium on bonds payable
Dec. 30 Interest expense
Premium on bonds payable
Cash
Note that the payment of the annual payment of the interest and the premium are
compounded in one entry.

Market price or issue price of the bond payable

It is equal to the present value of the principal bond liability plus the present value of the
future interest payments using the effective or market rate of interest.
Market price of bonds payable is equal to the sum of the ff.
a. PV of the bonds payable
b. PV of the totla interest payable
Present value of the principal bond liability= Face amt. of the bond x PV of 1 factor at
the effective rate for a number of interest periods.
Present value of the future interest payments = periodic nominal interest x PV of
ordinary annuity of 1 factor at the effective rate for a number of interest periods.

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 if an ordinary calculator.
1. Enter 1.05
2. Press the division sign twice.
3. Press the equal sign for the number of the interest periods required. Press once
for one period. In this case, press 6 times because there are 6 interest periods.
4. The result is the PV of 1 at 55 for 6 periods or .7462.
5. Deduct 1.00 from the result in No. 4. The result is .2538 negative,
6. Press the plus/ minus sign to remove the negative in No. 5
7. Divide the result in No. 6 bu .05.
8. The result is the PV of an ordinary annuity od 1 at 5% for 6 periods of 5.0757
Effective interest method- bond issue cost
PFRS 9 provides that the transaction cost that are are directly attributable to the issue if
a financial liability shall be included iin the initial measurement of the financial liability.
Transaction costs are defined as fees and commissions paid to agents, brokers, and
dealers levies by regulatory agencies and securities exchange, and transfer taxes and
duties. It also include bond issue costs.
Effective interest rate shall include all transaction costs, premiums and discounts.
Thus, bond issues costs will increase discount on bonds payable and will decrease
premium on bonds payable.
Under EIM, bond issue cost must be lumped with the discount on bonds payable and
netted against the premium on bonds payable.

Financial calculator (Discount and issue cost)

1. Enter negative P10, 000 (cash outflow for principal), press FV.
2. Enter negative P900, 000 (Cash flow for interest), press PMT.
3. Enter 3 (Maturity), press N
4. Enter positive P 9,511,330 (net proceeds), press PV
5. Press comp and i%
6. Press EXE
7. The financial calculator will yield an answer of 11%

Financial Calculator (Premium and bond issue cost)

1. Enter negative P10, 000,000 and press Fv.
2. Enter negative P1, 000,000 and press PMT.
3. Enter 5 and press N
4. Enter positive P 10, 300,000 and press PV.
5. Press comp and i%
6. Press EXE
7. The financial calculator will yield an answer of 9.23%.
Questions:

1. What method is required in amortizing discount on bonds payable, premium on

bond payable and bond issue cost?
2. What is a nominal rate of the interest?
3. What is a tated or coupon rate of interest?
4. What is an effective rate of interest?
5. What is a market or yield rate of interest?
6. Explain the effective interest method of amortization.
7. How is the interest expense computed under the effective interest method?
8. What is the “market price” of bond payable?
9. What is the treatment of the bond issue cost under the effective interest method?
10. What is the “trial and error” or “interpretation” process in computing the effective
rate?

Problems

1. (IAA)
Yellow Company received permission on january 1, 2019 to issue 12% bonds
with the face amount of P6, 000,000 maturing on January 1, 2019.
Interest is payable annually on Dec. 31. The bonds are callable at 102 plus
accrued interest. On January 1, 2019, the entity issued the bonds for P
6,737,000 with an effective yield of 10%.
The fiscal year of the entity ends December 31. The effective interest
amortization is used.
Required:
1. Prepare journal entries relating to the bonds payable for 2019.
2. Present the bonds payable on Dec. 31, 2019.

2. (ACP)

Clan Company issued 3 year 12% bonds with face amount of P2, 000,000. Interest is
payable semiannually April 1 and October 1.
The bonds were issued on April, 2019 for P2, 101, 520 which represents an effective
interest cost of 10% per year.

Required:

1. Prepare an amortization table using the effective interest method.

2. Prepare journal entries for 2019 and 2020.

3. (IAA)

On January 1, 2019, Katrina Company issued at par 5,000, 10% bonds with a fae
amount of P1, 000 per bond. The bonds have a five- year term, and pay interest
annually every Dec. 31 of each year.

The entity elected the fair value option in measuring the bonds payable.

On December 31, 2019 and 2020, the risk factors indicated that the rate of interest
applicable to the borrowings was 8% and 12% respectively.

PV of 1 8% 4 periods 0.735

PV of an ordinary annuity of 1 8% 4 periods 3.312

PV of 1 12% 3 periods 0.712

PV of an ordinary annuity of 1 12% 3 periods 2.404

Required:

Prepare journal entries for 2019, and 2020.