Effective Interest Method
A preferred procedure
for amortizing a discount or premium; also called present value amortization.
Under the effective interest method, interest expense is based
on the increasing (for discounts) or decreasing (for premiums) book value
of the bonds. The total interest expense for each interest period is the
carrying amount (book value) of the bonds at the start of that period
multiplied by the effective interest rate.
The amount of amortization of the bond discount or premium is the
difference between the total (effective) interest expense for the period
and the accrued nominal interest.
As the carrying amount changes each period by the amount of amortized
discount or premium, interest expense either increases (for discounts)
or decreases (for premiums) over the life of the bonds.
A schedule of
note discount amortization using the effective interest method for a $10,000,
three-year, 10% note discounted at 12% is appended.
(The present value of the note is $9,520.)