Introduction

PFRS 9 requires the use of Effective interest method in amortizing discount on bonds payable,
premium on bonds payable and bond issue cost.

Intended Learning Outcomes

After learning this chapter, the students should be able to:
1. Understand the effective interest method of amortizing bond premium, bond discount and bond
issue cost
2. Distinguish effective rate and nominal rate
3. Know the computation of the market price or issue price of bonds payable

EFFECTIVE INTEREST METHOD

Market price of bonds

PFRS 9 requires that discount on bonds payable, premium on bonds payable and bond issue cost
shall be amortized using the effective interest method.

This method distinguishes two kinds of interest rates, namely:

1. Nominal rate is the coupon or stated rate
2. Effective rate is 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 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.

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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.

Discount amortization = Effective interest - Nominal interest

Interest paid = Face amount x nominal rate
Interest expense = Carrying amount x effective rate
Discount amortization = Interest expense – interest paid
Carrying amount = preceding carrying amount + discount amortization

Illustration: Effective amortization of discount

On January 1, 2020, 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.

Interest Interest Discount Carrying

Date 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
Journal entries for 2020:
1/1/20 – Issuance of bonds
Cash 964,540
Discount on bonds payable (1,000,000 – 964,540) 35,460
Bonds payable (at face amount) 1,000,000

6/30/20 – Payment of semiannual interest and discount amortization for 6 months.

Interest expense 48,227
Cash (1,000,000 x 8% x 6/12) 40,000
Discount on bonds payable (See table of amortization) 8,227

12/31/20 – Payment of semiannual interest and discount amortization for 6 months.

Interest expense 48,638
Cash (1,000,000 x 8% x 6/12) 40,000
Discount on bonds payable (see table of amortization) 8,638

Note: Payment of semiannual interest and the periodic amortization of the discount are
compounded in one entry. This items can be recorded separately.

Effective amortization of premium

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 Premium amortization = Nominal interest – Effective interest
Interest paid = Face amount x nominal rate
Interest expense = Carrying amount x effective rate
Premium amortization = Interest paid – interest expense
Carrying amount = Preceding carrying amount – premium amortization

Illustration: Effective amortization of premium

On January 1, 2020, an entity issued three-year 12% bonds with face amount of P1,000,000
for P1,049,740, a price which will yield a 10% effective interest cost per year. The interest is
payable annually every December 31.

Interest Interest Premium Carrying

Date paid expense amortization 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

Journal entries for 2020 and 2021:

1/1/20 – Issuance of bonds.
Cash 1,049,740
Premium on bonds payable 49,740
Bonds payable (at face amount) 1,000,000

12/31/20 – Payment of annual interest.

Interest expense 120,000
Cash (1,000,000 x 12%) 120,000

12/31/20 - Premium amortization for 1 year.

Premium on bonds payable (See table of amortization) 15,026
Interest expense 15,026

12/31/21 – Payment of annual interest.

Interest expense 120,000
Cash (1,000,000 x 12%) 120,000

12/31/21 – Premium amortization

Premium on bonds payable (See table of amortization) 16,529
Interest expense 16,529
Note: The annual payment of interest and the premium amortization are recorded separately for
2020 and 2021.

Another illustration

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 On January 1, 2020, Wolf company issued 10% bonds in the face amount of P5,000,000,
which mature on January 1, 2030. The bonds were issued for P5,675,000 to yield 8%,
resulting in the premium of P675,000.
The entity used the interest method of amortizing bond premium. Interest is payable annually
on December 31.
Required:
1. What is the balance of the premium on bonds payable on December 31, 2020?
2. What is the carrying amount of bonds payable on December 31, 2020?

Answers:
Premium
Interest Carrying
Interest Paid amortizatio
Expense amount
Date n

Jan 1, 2020 5675000

Dec 31, 2020 500,000 454,000 46,000 5,629,000

1.
Premium on bonds payable (5,675,000 – 5,000,000) 675,000
Less: Premium amortization – 12/31/20 46,000
Balance of the premium on bonds payable – 12/31/20 629,000
2. Carrying amount of bonds payable on 12/31/20: 5,629,000

Market price or issue price of bonds 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 the future interest payments using the effective or
market rate of interest.
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.

In other words, the market price of bonds payable is equal to the sum of the following:
a. Present value of bonds payable (face amount of bonds x PV of 1 factor)
b. Present value of the total interest payments (Periodic nominal interest x PV of an ordinary
annuity of 1 factor)

Illustration 1: Interest is payable annually

Face amount of bonds 4,000,000
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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.
PV of 1 at 8% for 4 periods .7350
PV of an ordinary annuity of 1 at 8% for 4 periods 3.3121
Required: What is the market issue price of the bonds? Ans. 3,734,904

Answer: Present value of the principal (4,000,000 x .7350) 2,940,000

Present value of annual interest payments (240,000 x 3.3121) 794,904
Total Present value of the bonds 3,734,904

Interest Interest Discount Carrying

Date paid expense amortization amount
Jan. 1 , 2020 3,734,904
Dec. 31,2020 240,000 298,793 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: Interest is payable semiannually

Face amount of bonds 5,000,000
Nominal rate 12%
Effective rate 10%
The bonds are issued on January 1, 2020 and mature in 3 years on January 1, 2023. The interest
is payable semiannually. The PV 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
Required: What is the market issue price of the bonds? Ans. 5,253,710

Answer: PV of principal (5,000,000 x .7462) 3,731,000

PV of interest payment (300,000 x 5.0757) 1,522,710
Total present value of bonds 5,253,710

Note: The semiannual interest payment of P300,000 is computed by multiplying the face
amount of P5,000,000 by the semiannual nominal rate of 6% (12% / 2).

Interest Interest Premium Carrying

Date paid expense amortization amount
Jan. 1 2020 5,253,710
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June 30, 2020 300,000 262,686 37,314 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

Illustration 3: Serial bonds

Face amount of bonds 3,000,000
Nominal rate 12%
Effective rate 10%
Date of issue January 1,2020
Annual payment every December 31 1,000,000
Interest is payable annually December 31
Present value of 1 at 10%: One period 0.9091
Two periods 0.8264
Three periods 0.7513

Required: What is the market price of the serial bonds?Ans. 3,102,568

Answer: (a) (b) (a x b)

Principal Interest Total PV Present
Date payment payment payment factor value
12/31/20 1,000,000 360,000 1,360,000 0.9091 1,236,376
12/31/21 1,000,000 240,000 1,240,000 0.8264 1,024,736
12/31/22 1,000,000 120,000 1,120,000 0.7513 841,456
Total present value of serial bonds 3,102,568
Less: Face amount 3,000,000
Premium on bonds payable 102,568

Interest Interest Premium Principal Carrying

Date paid expense amortization payment amount
1/1/2020 3,102,568
12/31/2020 360,000 310,257 49,743 1,000,000 2,052,825
12/31/2021 240,000 205,282 34,718 1,000,000 1,018,107
12/31/2022 120,000 101,893 18,107 1,000,000 0

Journal entries for 2020 and 2021:

1/1/2020 – Issuance of bonds.
Cash 3,102,568
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 Premium on bonds payable 102,568
Bonds payable (at face amount) 3,000,000

12/31/20 – Payment of annual interest.

Interest expense 360,000
Cash (3,000,000 x 12%) 360,000

12/31/20 – Amortization of premium for 2020.

Premium on bonds payable (See table of amortization) 49,743
Interest expense 49,743
12/31/20 – First annual payment of principal.
Bonds payable 1,000,000
Cash 1,000,000
12/31/21 – Payment of annual interest.
Interest expense 240,000
Cash (2,000,000 x 12%) 240,000

12/31/21 – Amortization of premium for 2021and second annual payment of principal.

Premium on bonds payable (See table or amortization) 34,718
Interest expense 34,718
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
financial liability shall be included in the initial measurement of financial liability.
Transaction costs are fees and commissions paid to agents, advisers, brokers and dealers,
levies by regulatory agencies and security exchange, and transfer taxes and duties.
Transaction costs include bond issue costs.
These 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 P10,000,000 and
9% stated rate.
The bonds mature on January 1, 2023 and interest is payable annually on December 31.
The bonds are issued at P9,751,210 with an effective yield of 10% before considering the
bond issue cost.
The entity paid bond issue cost of P239,880.

Face amount 10,000,000

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Discount on bonds payable 248,790
Issue price 9,751,210
Bond issue cost 239,880
Net proceeds 9,511,330

Note: The effective rate is 10% but because of the bond issue cost, the effective rate must be
higher than 10%. 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 P9,511,330.

The effective rate cannot be computed algebraically but by means of trial and error or the
interpolation process.
By trial and error, using a new effective rate of 11%:
Present value of 1 for 3 periods is - .7312
Present value of an ordinary annuity of 1 is – 2.4437
The present value of the bonds payable using an interest rate of 11% is computed as follows:
PV of principal (10,000,000 x .7312) 7,312,000
PV of interest payments (900,000 x 2.4437) 2,199,330
Total present value of bonds 9,511,330

Journal entries for 2020:

1/1/2020 – Issuance of bonds.
Cash (10,000,000 – 248,790 – 239,880) 9,511,330
Discount on bonds payable (248,790 + 239,880) 488,670
Bonds payable (at face amount) 10,000,000
12/31/20 – Payment of annual interest and discount amortization using effective interest
method.
Interest expense (10,000,000 x 9%) 900,000
Cash 900,000
Interest expense 146,246
Discount on bonds payable (9,511,330 x11%) - (10,000,000 x 9%) 146,246

Illustration 2: Discount (with no effective rate) and bond issue cost

On January 1, 2020, an entity issued 5-year bonds with face amount of P10,000,000 at 95.
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 P200,000.

Face amount 10,000,000

Discount on bonds payable 500,000
Issue price (10,000,000 x .95) 9,500,000
Bond issue cost 200,000
Net proceeds 9,300,000

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Again, the problem is to find an effective rate applicable to the proceeds of P9,300,000.
Since, the bonds are issued at a discount, the effective rate must be higher than nominal rate
of 10%.
By interpolation, using a rate of 11%, the PV of 1 for 5 periods is .5935 and the PV of an
ordinary annuity of 1 is 3.6959. The total present value of bonds would be P9,630,900.

The net proceeds of P9,300,000 are lower than the present value of bonds payable of
P9,630,900 using 11% interest rate. This means that the effective rate must be higher than
11%.
So, another interpolation is made using the rate of 12%. The PV of 1 for 5 periods at 12% is .
5674. The PV of an ordinary annuity of 1 for 5 periods at 12% is 3.6048. Thus, the total
present value of bonds would be P9,278,800.
This time, the net proceeds of P9,300,000 are higher than the present value of bonds payable
of P9,278,800 using 12% interest rate. This means that the effective rate must be lower than
12%.
In conclusion, the effective interest rate must be between 11% and 12%.
The difference between 11% and 12% is interpolated as follows:
Let X as the unknown effective interest rate
(X – 11%) / (12% - 11%)
(9,300,000 – 9,630,900) / (9,278,800 – 9,630,900)
330,900 / 352,100 = 0.94

This difference of .94 between 11% and 12% is added to 11% to get an effective rate of
11.94%.
Thus, the PV of 1 for 5 periods at 11.94 % effective rate is .56895 and the PV of an ordinary
annuity of 1 for 5 periods at 11.94% effective rate is 3.61014. The present value of bonds is
computed as follows:
PV of principal (10,000,000 x .56895) 5,689,500
PV of interest payments (1,000,000 x 3.61014) 3,610,140
Total present value of bonds 9,299,840 or 9,300,000

Illustration : Retirement of bonds

Nixon Company reported 10% bonds payable with carrying amount of P5,700,000 on
January 1, 2020. 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, 2020, the entity retired the bonds at 102. The interest payment on July 1, 2020 was
made as scheduled.
Required:
1.What is the carrying amount of bonds payable on July 1, 2020?
2. What amount should be recorded as loss on the early extinguishment of the bonds?

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Answers:
1. Interest expense (5,700,000 x 12% x 6/12) 342,000
Interest paid (6,000,000 x 10% x 6/12) 300,000
Discount amortization – 7/1/2020 42,000
Add: carrying amount – 1/1/2020 5,700,000
Carrying amount of bonds payable – 7/1/2020 5,742,000

2. Carrying amount of bonds payable -7/1/2020 5,742,000

Less; Retirement price (6,000,000 x 1.02) 6,120,000
Loss on the early retirement of bonds 378,000

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