Chapter 6

EFFECTIVE INTEREST METHOD

Market price of bonds
Introduction

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

The effective interest method is also known as scientific method or simple “interest method”

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 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 face amount: effective rate = nominal rate

When bonds are sold at premium: ER<NR

When bonds are sold at a discount: ER>NR

Effective interest method

Effective interest rate = effective rate * carrying amount of the bond

Carrying amount of the bonds changes every year as the amount of premium or discount is amortized periodically.

Premium amortization
Nominal interest (NR * face amount) xxx
Less: Effective interest (ER * carrying amount) xxx
Premium amortization xxx

Discount amortization
Effective interest xxx
Less: Nominal interest xxx
Discount amortization xxx
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.

Schedule of amortization

Date Interest paid Interest expense Premium amortization Carrying 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

Jan 1. Cash 1,049,740
Bonds payable 1,000,000
Premium on bonds payable 49,740

Dec. 31 Interest expense 104,974

Premium on bonds payable 15,026
Cash 120,000
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.

Schedule of amortization

Date Interest paid Interest expense Discount amortization Carrying amount

Jan. 1, 2020 964,540
Jun. 30, 2020 40,000 48,227 8,227 972,767
Dec. 31, 2020 40,000 48,638 8,638 981,405
Jun. 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

Jan 1. Cash 964,540 Dec. 30 Interest expense 48,638
Discount on bonds payable 35,460 Cash 40,000
Bonds payable 1,000,000 Discount on bonds payable 8,638

June 30. Interest expense 48,227

Cash 40,000
Discount on bonds payable 8,227
Market price or issue price of bond payable

The market price or issue price of bond payable is equal to the present value of the principal bond liability plus the
present value of future interest payment 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:
a. Present value of bonds payable
b. Present value of the total interest payments

Present value of the principal bond liability = Face amount * Present value of 1
Present value of the future interest payments = Interest * Present value of an ordinary annuity of 1
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 of an ordinary calculator.

1. Enter 1.05
2. Press the division sign (÷) twice.
3. Press the equal sign (=) for the number of interest periods required.
4. The result is the PV of 1 at 5% 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 (+/-) to remove the negative in No.5
7. Divide the result in No. 6 by .05
8. The result in the PV of an ordinary annuity of 1 at 5% for 6 periods or 5.0757.
Illustration 1

Face amount of bonds 4,000,000

Nominal rate 6%
Effective rate 8%

The bonds are issued on January 1, 2020 and mature on four years on January 1, 2024. The interest is payable
annually every December 31.
Since the interest is payable annually, there are 4 interest periods. The relevant present value factors are:
PV of 1 at 8% for 4 periods .7350
PV of an ordinary annuity of 1 at 8% for 4 periods 3.3121

Computation of present value of the bonds

Present value of principal (4,000,000*.7350) 2,940,000
Present value of annual interest payments
(240,000*3.3121) 794,904
Total present value 3,734,904

Face amount 4,000,000

Market price or issue price 3,734,904
Discount on bonds payable 265,906
Table of amortization

Discount
Date Interest paid Interest expense amortization Carrying amount
Jan. 1, 2020 3,734,904
Dec. 31, 2020 240,000 298,792 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

Face amount of bonds 5,000,000

Nominal rate 12%
Effective rate 10%

The bonds are issued on January 1, 2020 and mature in three years on January 1, 2023. The interest is payable
semiannually every June 30 and December 31.
Since the interest is payable semiannually, there are 6 interest periods. The present value 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

PV of principal (5,000,000*.7462) 3,731,000

PV of interest payments (300,000*5.0757) 1,522,710
Total PV 5,253,710

Market price or issue price of bonds 5,253,710

Face amount 5,000,000
Premium on bonds payable 253,710
Table of amortization

Premium
Date Interest paid Interest expense amortization Carrying amount
Jan. 1, 2020 5,253,710
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 .9091
Two period .8264
Three period .7513

Present value of the bonds payable

(a) (b) (a*b)
Date Principal Payment Interest Payment Total payment PV factor Present value
12/31/2020 1,000,000 360,000 1,360,000 .9091 1,236,376
12/31/2021 1,000,000 240,000 1,240,000 .8264 1,024,736
12/31/2022 1,000,000 120,000 1,120,000 .7513 841,456
Total present value 3,102,568
Face amount 3,000,000
Premium on bonds payable 10,568
Table of amortization
Premium Principal Carrying
Date Interest paid Interest 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 -

Journal entries for 2020

1. Issuance of bonds: 4. Payment of principal:
Cash 3,102,568 Bond payable 1,000,000
Bonds payable 3,000,000 Cash 1,000,000
Premium on bonds payable 102,568

2. Payment of interest:
Interest expense 360,000
Cash 360,000

3. Amortization of premium:
Premium on bonds payable 49,743
Interest expense 49,743
Effective interest method – bond issue cost

PFRS 9 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 cost are defined as fees and commissions paid to agents, advisers, brokers and dealers, levies by
regulatory agencies and securities exchanges, and transfer taxes and duties. Clearly, transactions costs include
bond issue costs.

The calculation of effective interest rate shall include all transactions costs, premiums and discounts.

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

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

By interpolation and using an effective rate of 11%, the present value of 1 for 3 periods is .7312

The present value of an ordinary annuity of 1 for 3 periods at 11% is 2.4437

The present value of the bonds payable using an interest rate of 11% is determined as:

PV of principal (10,000,000*.7312) 7,312,000

PV of interest payments (900,000*2.4437) 2,199,330
Total present value 9,511,330

The new effective rate is 11%

Illustration 2 – Discount 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*95%) 9,500,000
Bond issue cost ( 200,000)
Net proceeds 9,300,000

By interpolation, using a rate of 11%, the PV of 1 for 5 periods is .5935

The PV of an ordinary annuity of 1 for 5 periods at 11% is 3. 6959

PV of principal (10,000,000*.5935) 5,935,000

PV of interest payments (1,000,000*3.6959) 3,695,900
Total PV 9,630,900
Another interpolation using rate of 12%

PV of 1 for 5 periods at 12% is .5674

PV of an ordinary annuity of 1 for 5 periods at 12% is 3.6048

PV of principal (10,000,000*.5674) 5,674,000

PV of interest payments (1,000,000*3.6048) 3,604,800
Total present value 9.278,800

The net proceeds of P9,300,00 are higher than the present value of the 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 rate must be between 11% and 12%

X - 11% 9,300,000 – 9,630,000 330,900 = .94

12% - 11% 9,278,800 – 9,630,900 352,100

This differential of .94 between 11% and 12% is added to 11% to get an effective interest rate of 11.94%
Illustration 3 – Premium and bond issue cost

On January 1, 2020, an entity issued 5-year bonds with face amount of P10,000,000 at 105. The nominal rate
is 10% and the interest is payable annually on December 31.
The bond mature on January 1, 2025. The entity paid bond issue cost of P200,000.

Face amount 10,000,000

Premium on bonds payable 500,000
Issue price (10,000,000*105%) 10,500,000
Bond issue cost ( 200,000)
Net proceeds 10,300,000

Cash 10,300,000
Bonds payable 10,000,000
Premium on bonds payable 300,000

Since the bonds are issued at premium, the effective rate must be lower than 10%
By interpolation, using a rate of 9%, the PV of 1 for 5 periods is .6499 and present value of an ordinary annuity of 1
is 3.8897.

PV of principal (10,000,000*.6499) 6,499,000

PV of interest payments (1,000,000*3.8897) 3,889,700
Total present value 10,388,700

The effective rate must be between 9% and 10%

X - 9% 10,300,000 – 10,388,700 88,700

= .23
10% - 9% 10,000,000 – 10,388,700 388,700

Thus, the effective rate is 9.23%