How It Works
The effective interest method calculates interest expense using the MARKET rate × carrying value. Cash paid is the STATED rate × face value. The difference between interest expense and cash paid is the amortization of the discount or premium.
Discount Amortization
$100,000 bond, 6% stated, 8% market, carrying value $86,580. Interest Expense = $86,580 × 8% = $6,926. Cash Interest = $100,000 × 6% = $6,000. Discount Amortization = $6,926 − $6,000 = $926. New carrying value = $86,580 + $926 = $87,506.
Premium Amortization
$100,000 bond, 8% stated, 6% market, carrying value $114,720. Interest Expense = $114,720 × 6% = $6,883. Cash Interest = $100,000 × 8% = $8,000. Premium Amortization = $8,000 − $6,883 = $1,117. New carrying value = $114,720 − $1,117 = $113,603.
CPA Exam Tip
Interest expense changes each period under the effective interest method (because carrying value changes). Cash interest stays constant. GAAP prefers the effective interest method over straight-line.