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Effective Interest Method (Chapter 6)

This document provides an overview of the effective interest method for accounting for bonds payable, premiums, discounts, and bond issue costs under intermediate accounting. It defines key terms like nominal interest rate, stated/coupon rate, effective rate, market/yield rate. It explains that the effective interest method is required and computes interest expense by multiplying the carrying amount by the effective rate semiannually. Bond issue costs are amortized as interest expense over the bond's life, increasing interest expense as the book value increases. A "trial and error" process may be needed to compute the effective rate.

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619 views2 pages

Effective Interest Method (Chapter 6)

This document provides an overview of the effective interest method for accounting for bonds payable, premiums, discounts, and bond issue costs under intermediate accounting. It defines key terms like nominal interest rate, stated/coupon rate, effective rate, market/yield rate. It explains that the effective interest method is required and computes interest expense by multiplying the carrying amount by the effective rate semiannually. Bond issue costs are amortized as interest expense over the bond's life, increasing interest expense as the book value increases. A "trial and error" process may be needed to compute the effective rate.

Uploaded by

klife
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Intermediate Accounting 2

Homework
Effective Interest Method (Chapter 6)

Chapter 6

1. What method is required in amortizing discount on bonds payable, premium on bonds


payable and bond issue cost?
a. The method is effective interest method.
2. What is a nominal rate on interest?
a. It the coupon or stated rate.
3. What is stated or coupon rate of interest?
a. Coupon rate is the stated interest rate on a fixed income security like a bond. In other
words, it's the rate of interest that bondholders receive from their investment. It's
based on the yield as of the day the bond is issued.
4. What is an effective rate of interest?
a. It is the yield or market rate.
5. What is a market or yield rate of interest?
a. Current yield compares the coupon rate to the current market price of the bond. In
other words, is the interest paid on bond or loan stock or etc., expressed as a
percentage of the current market price of the bond or stock.
6. Explain the effective interest method of amortization.
a. It is computed as:
Nominal interest (nominal rate x face amount) xxx
Less: Effective interest (effective rate x carrying amount) xxx

Premium Amortization xxx

Effective interest xxx


Less: Nominal interest xxx

Discount Amortization xxx

7. How is interest expense computed under the effective interest method?


a. This is computed by multiplying the carrying amount and the semi-annual effective rate.
8. What is the “market price” of bond payable?
a. This is also called as issue price whereas the price of bonds payable is equal to the
present value of the principal bond liability plus the present value of future interest
payments using the effective or market rate of interest.
9. What is the treatment of bond issue cost under the effective interest method?
a. The effective interest method is used to discount, or write off, a bond. The amount of
the bond discount is amortized to interest expense over the bond's life. As a bond's
book value increases, the amount of interest expense increases.
10. What is the “trial and error” or “interpolation” process in computing the effective rate?
The bond issue cost must be “lumped” with the discount on bonds payable and “netted”against
the premium on bonds payable.

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