How does the effective interest method work for bond amortization?

The effective interest method ensures that interest expense each period reflects a constant yield (the market rate at issuance) applied to the bond's carrying value. This is required under both IFRS and US GAAP.

Key Principle:

• Interest expense = Carrying value x Market rate (at issuance)
• Coupon payment = Face value x Coupon rate
• Amortization = Difference between interest expense and coupon payment

Discount Bond Example:

Galveston Energy issues a $1,000,000 face value, 3-year bond with a 4% annual coupon when the market rate is 6%. Coupons paid annually.

Issuance price = PV of coupons + PV of principal

= $40,000 x [(1 - 1.06^-3)/0.06] + $1,000,000 x 1.06^-3

= $40,000 x 2.6730 + $1,000,000 x 0.8396

= $106,920 + $839,619 = $946,539

How it works: Interest expense exceeds the coupon payment for a discount bond, so the carrying value increases toward par each period. The amortization is added to the bond's carrying value.

Premium Bond — Reverse Logic:

If the coupon were 8% and market rate 6%, the bond would sell above par. Interest expense would be less than the coupon, and carrying value would decrease toward par.

Cash Flow Classification:

• Coupon payments: Operating cash outflow (most of the time)
• Principal at maturity: Financing cash outflow
• Under IFRS, interest paid can be classified as either operating or financing

Key exam tip: Under the effective interest method, interest expense changes each period because the carrying value changes. Under the straight-line method (allowed under US GAAP as a simplification), amortization is the same each period. If a question says 'effective interest method,' the expense must reflect the market rate times the current carrying value.

Practice bond amortization schedules in our CFA Level I FRA course.