LOS B requires us to:
describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments
There are two methods of accounting for bonds. These are: effective interest method and the straight-line method. They are discussed in details below:
1. Effective Interest Method
a. This is the preferred method for accounting for bonds under GAAP. However, IFRS mandatorily requires the use of this method.
b. This method is mostly applied when the bonds are issued at a discount or premium. In these cases, the market rate of interest is not equal to the coupon payments.
c. In these cases, the coupon is adjusted for the amortization of premium/discount.
i.e.
Interest Expense ± Coupon Payments = Amortization of Discount / Premium |
d. According to this method, a constant rate of interest, which is usually the market rate of interest, is applied to the carrying value each period to calculate the interest expense.
2. Straight Line Method
a. This method is permitted under GAAP only, but this is not the preferred method of accounting for bonds.
b. As the name suggests, as per this method, the discount or premium on the issue of bond is amortized evenly over the life of the bond.
We can explain the two methods with the help of the following example:
Example:Suppose, there is an issue of 1000 5 % 5-year bonds with a par value of $ 1000 each. The market rate of return t the time of issue of the bond was 5.5 %. The present value of all the cash flows (including the coupon and principal repayment), discounted at the rate of 5.5 % is $ 978,648.58. And, the difference of $ 21,351.42 would be amortized each year according to the following schedule:
However, if the discount was to be amortized using the straight-line method, it would have been amortized $ 4,270.28 (i.e. $ 21,351.42 / 5) each year. The bonds issued at a premium can also be amortized in a similar fashion. It’s just that, the premium is reduced from the carrying value (instead of adding). |
3. Fair Value Reporting
When we report a bond at fair value in the balance sheet, it represents discounting at the market rate at the time when the bonds were issued. These market rates do not always remain the same. They are also subject to increase or decrease.
There is an inverse relationship between the bond price and the interest rates prevailing in the market. So, if the market rates are falling, the price of bonds rises, and vice-a-versa. Thus, when the market rates are falling the historical carrying value (i.e. the one calculated at the time of issue of bond), understates the leverage levels because the market value of the bonds is higher. And, when the market rates are decreasing the historical carrying costs overstate the leverage levels.
Both IFRS and GAAP give firms the irrevocable option to report the bonds at a fair value. Under this option, the profits or losses that result from the change in the market rates are reported in the income statement.