Why does the carrying value of a bond move under the effective interest method?

Question

AcadiFi · Accepted Answer

Under the effective interest method, interest expense equals the bond's carrying value times the market rate at issuance. Cash paid, however, is based on the coupon rate times face value. The difference between interest expense and cash paid amortizes the discount or premium. A discount bond starts below face and grows upward because interest expense exceeds cash paid. A premium bond starts above face and falls downward because cash paid exceeds interest expense.

Example: Granite Harbor Logistics issues $500,000 of 8 percent bonds when the market rate is 10 percent, so the bonds sell for $462,000. Semiannual cash interest is $20,000. First-period interest expense is $462,000 x 5 percent = $23,100. Because expense exceeds cash by $3,100, the discount amortizes by $3,100 and carrying value rises to $465,100. If instead the bond had been issued at $536,000 because the coupon exceeded the market rate, first-period expense would be $26,800 and cash paid would still be $20,000, so the premium would amortize downward by $6,800.

The conceptual point is that the carrying value is marching toward face value by maturity. The effective rate reflects the true economic cost of borrowing at issuance, while the coupon only determines cash. On FAR, always separate interest expense from cash interest when using effective interest. Practice more in our CPA FAR question bank.

Why does the carrying value of a bond move under the effective interest method?

Master FAR with our CPA Course

Related Questions

Practice Questions