FINANCIAL ACCOUNTING & REPORTING 1

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Accounting for Investments in Equity and Debt Instruments

Module 013 Effective Interest Method

At the end of this module, you will be able to:

1. Be familiar with the effective interest method
2. Apply effective interest method for the financial asset at amortized costs.
The common applications of the lessons under this module consist of the
application of the effective interest method in accounting for financial assets
at amortized cost.
Effective Interest Method
Introduction
PFRS 9 requires that the bond discount and the bond premium shall be amortized using the
effective interest method. The effective interest method is also known as the scientific
method or simply the "interest method."
This method distinguishes two kinds of interest rates, namely nominal rate, and effective
rate.
The nominal rate is the coupon rate or stated rate appearing on the face of the bond. The
effective rate is the yield rate or market rate, which is the actual or true rate of interest that
the bondholder earns on the bond investment.
The effective rate is the rate that exactly discounts estimated future cash payments through
the expected life of the bond or, when appropriate, a shorter period to the net carrying
amount of the bond.

Effective rate versus nominal rate

The effective rate and the nominal rate are the same if the cost of the bond
investment is equal to the face value.
When the bonds ate acquired at a premium, the effective rate is lower than the
nominal rate. The reason is that the premium is a loss on the part of the bondholder.
On the other hand, when the bonds are acquired at a discount, the effective rate is
higher than the nominal rate. The reason is that the discount is a gain on the part of
the bondholder. The effective rate and nominal rate are necessary for applying the
effective interest method.
Effective interest method

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 The effective interest method simply requires the comparison between the interest
earned or interest income and the interest received. The difference between the two
represents the premium or discount amortization.
Interest method or interest income is computed by multiplying the effective rate by
the carrying amount of the bond investment.
Interest received is computed by multiplying the nominal rate by the face amount of
the bond.
The carrying amount of the bond investment is the initial cost gradually increased
by periodic amortization of discount or gradually reduced by periodic amortization
of premium.
Effective interest method-Discount
On January 1, 2015, an investor acquired P1,000,000 face amount bonds dated
January 1, 2015. The life of the bonds is two years, and 8% interest is payable
semiannually on June 30 and December 31. The cost of the bonds is P964,540, a
price that will yield a 10% effective rate per year.
The amortization may appear as follows:
Date Interest Interest Discount Carrying
received income amortization amount
Jan. 1, 2015 964,540
Jun. 30, 2015 40,000 48,227 8,227 972,767
Dec. 31, 2015 40,000 48,638 8,638 981,405
Jun 30, 2016 40,000 49,070 9,070 990,475
Dec. 31, 2016 40,000 49,525 9,525 1,000,000
Interest received- Face amount of P1,000,000 times the semiannual nominal rate of
4% or P40,000.
Interest income- Carrying amount times semiannual effective rate. Thus, for the
period January 1 to June 30, 2015, the interest income is P964,540 times 5% or
P48,227.
Discount amortization- Interest income minus interest received. Thus, on June 30,
2015, the amortization was P48,227 minus P40,000 or P8,227.
Carrying amount-Preceding carrying amount plus the discount amortization. Thus,
on June 30, 2015, the carrying amount was P964,540 plus P8,227 or P972,767.
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Accounting for Investments in Equity and Debt Instruments

Journal entries for 2015

Jan 1 Investment in bonds 964,540
Cash 964,540
Acquisition of the bonds

Jun 30 Cash 40,000

Interest income 40,000
Semiannual interest received

Jun 30 Investment in bonds 8,227

Interest income 8,227
Amortization of discount for 6 months

Dec 31 Cash 40,000

Interest income 40,000

Dec 31 Investment in bonds 8,638

Interest income 8,638
Amortization of discount for last 6 months.
Note that the amortization is done on every interest date rather than at the end of
the reporting period.
Effective interest method-Premium
On January 1, 2015, an investor acquired P1,000,000 face amount bonds dated
January 1, 2015. The bonds mature in 3 years and bear 12% interest payable
annually every December 31. The cost of bonds is P1,049,740, a price that will yield
an effective interest of 10%.
Date Interest Interest Discount Carrying
received income amortization amount
Jan. 1, 2015 1,049,740
Dec. 31, 2015 120,000 104,974 15,026 1,034,714
Dec. 31, 2016 120,000 103,471 16,529 1,018,185
Dec. 31, 2017 120,000 101,815 18,185 1,000,000

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 Interest received- Face amount of P1,000,000 times the annual nominal rate of 12%
or P120,000.
Interest income- Carrying amount times annual effective rate. Thus, for 2015, the
interest income is P1,049,740 times 10% or P104,974.
Premium amortization- Interest received minus interest income. Thus, on December
31, 2015, the premium amortization was P120,000 minus P104,974 or P15,026.
Carrying amount- Preceding carrying amount minus premium amortization. Thus,
on December 31, 2015, the carrying amount is P1,049,740 minus P15,026 or
P1,034,714.
Journal entries for 2015
Jan 1 Investment in bonds 1,049,740
Cash 1,049,740
Dec 31 Cash 120,000
Interest income 120,000
Dec 31 Interest income 15,026
Investment in bonds 15,026
Effective interest method- Serial bonds
Face amount of bonds 4,000,000
Acquisition cost 4,171,810
Premium on the bonds 171,810
Annual installment on December 31, 2015
And every December 31 thereafter 1,000,000
Date of issue January 1, 2015
Nominal interest rate payable annually every Dec. 31 10%
Effective interest rate 8%
The table of amortization may appear as follows:
Date Interest Interest Premium Principal Carrying amount
received income amortization payment
1/1/2015 4,171,810
12/31/2015 400,000 333,745 66,255 1,000,000 3,105,555
12/31/2016 300,000 248,444 51,556 1,000,000 2,053,999
12/31/2017 200,000 164,320 35,680 1,000,000 1,018,313
12/31/2018 100,000 81,681 18,319 1,000,000 -
Interest received equals outstanding face amount times nominal rate. Thus, on
December 31, 2015, P4,000,000 times 10% equals P400,000, and on December 31,
2016, P3,000,000 times 10% equals P300,000 and so on.
Interest income equals carrying amount times effective times effective rate. Thus,
for 2015, P4,171,810 times 8% equals P333,745, and so on.
Premium amortization equals interest received minus interest income. Thus, on
December 31, 2015, P400,000 minus P333,745 equals P66,255 and so on.
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Accounting for Investments in Equity and Debt Instruments

Carrying amount equals preceding carrying amount minus principal payment and
minus premium amortization.
Thus, on December 31, 2015, P4,171,810 minus P1,000,000 minus P66,255 equals
P3,105,555.

Journal entries for 2015

Jan 1 Investment in bonds 4,171,810
Cash 4,171,810
Dec. 31Cash 1,400,000
Investment in bonds 1,000,000
Interest income 400,000
Dec 31 Interest income 66,255
Investment in bonds 66,255

Bond investment-FVOCI
PFRS 9, provides that a financial asset shall be measured at fair value through other
comprehensive income if both of the following conditions are met:
a. The business model is achieved both by collecting contractual cash flows
and by selling the financial asset.
b. The contractual cash flows are solely payments of principal and interest
on the principal outstanding.
Note that the business model includes selling the financial asset in addition to
collecting contractual cash flows. In this case, interest income is recognized using
the effective interest method as in amortized cost measurement.
On derecognition, the cumulative gain or loss recognized in other comprehensive
income shall be reclassified to profit or loss.
Illustration
On January 1, 2015, an entity purchased bonds with a face amount of P5,000,000 for
P4,760,000, including transactions costing P160,000. The business model is to
collect contractual cash flows and sell the financial asset. The bonds mature on
December 31, 2017, and pay 10% interest annually on December 31 with a 12%
effective yield.
Financial asset-FVOCI 4,760,000
Cash 4,760,000

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Note that, unlike trading bond investment, the transaction cost is included in the
cost of a financial asset measured at fair value through OCI.
Journal entry to record the annual interest received
Cash (10%x5,000,000) 500,000
Interest income 500,000
PFRS 9 mandates that interest income for bond investment measured at fair value
through other comprehensive income must be calculated using the effective interest
method and included in profit or loss.
Accordingly, this would require the amortization of any discount or premium on the
bond investment.
Face amount 5,000,000
Acquisition cost 4,760,000
Discount 240,000
Amortization of discount on December 31, 2015
Financial assert-FVOCI 71,200
Interest income 71,200

Date Interest Interest Discount Carrying amount

received income amortization
1/1/2015 4,760,000
12/31/2015 500,000 571,200 71,200 4,831,200
12/31/2016 500,000 579,744 79,744 4,910,944
12/31/2017 500,000 589,056 89,056 5,000,000

Explanation
Interest received equals the face amount of P5,000,000 times the nominal rate of
10% or P500,000.
Interest income equals the carrying amount times the effective rate. Thus, on
December 31, 2015, P4,760,000 times 12% equals P571,200 and so on.
Discount amortization equals interest income minus interest received. Thus, for
2015, P571, 200 minus P500,000 equals P71,200, and so on.
Carrying amount equals preceding carrying amount plus discount amortization.
Thus on December 31, 2015, P4,760,000 plus P71,200 equals P4,831,200 and so on.
On December 31, 2015, the bond investment was measured at fair value through
other comprehensive income.
Assume the bonds are quoted at 102 on this date.
Market value (5,000,000x102%) 5,100,000
Carrying amount- December 31, 2015 4,831,200
Unrealized gain-OCI 268,800
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Accounting for Investments in Equity and Debt Instruments

Financial asset-FVOCI 268,800

Unrealized gain-OCI 268,800
Subsequently, the entity must record discount amortization of P79,744 for 2016 and
P89,056 for 2017 in accordance with the effective interest table of amortization
regardless of the change in market value.
The resulting carrying amount should then be adjusted to conform with the market
value on December 31, 2016, and 2017.
Fair value option
PFRS 9 provides that an entity at initial recognition may irrevocably designate a
financial asset as measured at fair value through profit or loss even if the financial
asset satisfies the amortized cost measurement.
In other words, investments in bonds can be designated without revocation as
measured at fair value through profit or loss, even if the bonds are held for
collection as a business model.
Under the fair value option, all changes in fair value are recognized in profit or loss.
Accordingly, any transaction cost incurred is an outright expense. Moreover, the
interest income is based on the nominal interest rate rather than the effective
interest rate.
Illustration
On January 1, 2015, an entity purchased bonds with a face amount of
P5,000,000 for P5,400,000 plus a broker commission of P100,000.
The stated interest rate is 8%, payable annually every December 31. The
bonds are acquired to yield an effective rate of 6%. On December 31, 2015,
the bonds had a fair value of P5,600,000.
Journal entries for 2015
a. Financial asset-FVPL 5,400,000
Commission expense 100,000
Cash 5,500,000
b. Cash (8%x5,000,000) 400,000
Interest income 400,000
c. Financial asset-FVPL 200,000
Gain from change in fair value 200,000
(5,600,000-5,400,000)

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Computation of effective rate
On January 1, 2015, an entity purchased bonds with a face amount of P5,000,000 at
the cost of P4,650,000. The nominal interest rate is 10%, payable annually every
December 31. The bonds mature on January 1, 2020, or in 5 years.
There is no algebraic or mathematical formula for computing the effective rate on
the bonds. The effective rate is determined by means of "trial and error" or the so-
called "interpolation process." In this case, a mathematical table of present value is
necessary.
Better still, the teacher should teach the students how to compute the present value
factor using an ordinary calculator.
Basic theory
The basic theory is to find an effective rate that would equate the acquisition cost
and the present value of the future cash flows from the bonds.
Since the acquisition cost is at a discount, the effective rate must be higher than the
nominal rate of 10%. By interpolation, using a rate of 11%, the present value of 1 for
5 periods is 0.5935, and the present value of an ordinary annuity of 1 for 5 periods
is 3.6959.
PV of principal (5,000,000x.5935) 2,967,500
PV of future interest payments (500,000x.6959) 1,847,950
Total present value of cash flows 4,815,450
The acquisition cost of P4,650,000 is still lower than the present value of the bonds
of P4,815,450 using 11% interest rate. This means that the effective rate must be
higher than 11%.
Another interpolation
So another interpolation is made using another rate of 12%. The present value of 1
for 5 periods at 12% is 0.5674, and the present value of an ordinary annuity of 1 for
5 periods at 12% is 3.6048.
PV of principal (5,000,000x.5674) 2,837,000
PV of future interest payments (500,000x3.6048) 1,802,400
Total present value of cash flows 4,639,400
The acquisition of P4,650,000 is now higher than the present value of bonds of
P4,639,400 using 12% interest rate. This means that the effective rate must be
lower than 12%.
Conclusion
The effective rate must be between 11% and 12%.
With this scenario, the differential between 11% and 12% is interpolated as follows.
(Let X as the unknown effective rate):
X-11%
12%-11%
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Accounting for Investments in Equity and Debt Instruments

The present value applicable to the rates is substituted as follows:

4,650,000-4,815,450
4,639,400-4,815,450

165,450 =.94
176,050

This different of .94 between 11% and 12% is added to 11% to get an effective rate
of 11.94%.
Financial calculator
Actually, the effective rate can easily be determined through the use of a financial
calculator. In practice, this is usually the case. Observe the following process:
1. Enter negative P5,000,000 (cash flow for principal) and press FV
2. Enter negative P500,000 (cash flow for interest) and press PMT.
3. Enter 5 (maturity) and press N.
4. Enter positive P4,650,000 (acquisition cost) and press PV
5. Press comp (compute) and i% (effective rate)
6. Press EXE (execute)
7. The financial calculator will yield an answer of 11.94%.
The purchase price or market price of bonds
An investor may wish to know in advance the total cash outlay for the bond
investment of a specified rate of return.
The procedures for the computation of the purchase price of bonds are:
1. Using the effective rate, find the present value of an ordinary annuity of 1 for the
number of interest periods involved.
2. Multiply the nominal rate by the face amount of the bonds for one interest
period.
3. Also, multiply the effective rate by the face amount for one interest period. Get
the difference between the two products.
4. The difference computed in No.2 is multiplied by the present value factor
determined in No.1. the answer represents either a discount or premium.
If the effective rate is higher than the nominal rate, the answer in No. 3 is a discount.
If the effective rate is lower than the nominal rate, the answer in No. 3 is a premium.
5. The face amount of the bonds plus premium or minus discount equals the
purchase price of the bond.

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Illustration 1- on interest date
What is the purchase price of the bonds on January 1, 2015?
Face amount of bonds P3,000,000
Date of issue of bonds January 1, 2015
Nominal rate 8%
Effective rate 6%
Semiannual interest January 1 and July 1
Date of maturity January 1, 2017

Solution
1. Find the present value of an ordinary annuity of 1 for four interest periods (2
years), using the effective semiannual rate of 3% per interest period. The
present value of an ordinary annuity of 1 for four periods at 3% is 3.7171.
2. Semiannual nominal rate times face amount.
(4% x 3,000,000) 120,000
Semiannual effective rate times face amount
(3% x 3,000,000) 90,000
Difference 30,000
3. 3.7171 times P30,000 equals P111,513. This amount is a premium because the
effective rate is lower than the nominal rate.
4. Purchase price= P3,000,000 plus P111,513 or P3,111,513.

Illustration 2- on interest date

What is the purchase price of the bonds on January 1, 2015?
Face amount of the bonds P3,000,000
Date of issue of bonds January 1, 2015
Nominal rate 6%
Effective rate 8%
Interest payable annually December 31
Date of maturity January 1, 2018
Solution using another approach
The following present value factors are necessary:
PV of an ordinary annuity of 1 at 8% for three periods 2.5771
PV of 1 at 8% for three periods 0.7938
The market price of the bonds is computed as follows:
PV of principal (3,000,000x.7938) 2,381,40
PV of future interest payments 463,878
Total market price 2,845,278
Illustration 3- between interest dates
What is the purchase price of the bonds on March 31, 2015?
Face amount of the bonds P3,000,000
Date of issue of bonds January 1, 2015
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Accounting for Investments in Equity and Debt Instruments

Nominal rate 8%
Effective rate 6%
Semiannual interest payments on January 1 and July 1
Date of maturity January 1, 2020
Solution:
1. The present value of an ordinary annuity of 1 for 10 interest periods (5 years)
using the effective semiannual rate of 3% is 8.5302.
2. Semiannual nominal rate times face amount.
(4%xP3,000,000) 120,000
Semiannual effective rate times face amount 90,000
Difference 30,000
3. 8.5302 times P30,000 equals P255,906. This amount is a premium because the
effective rate is lower than the nominal rate.
4. P3,000,000 plus P255,906 equals P3,255,906. This amount would have been the
purchase price had the bonds been purchased on January 1, 2015.

To find the purchase price on March 31, 2015, it is necessary to prepare a partial
table of amortization:

Interest Interest Interest Premium Carrying

date received (4% income(3% of amortization amount
face amount) carrying amount)
Jan.1, 2015 3,255,906

Jul 1, 2015 120,000 97,677 22,323 3,233,583

Note that the premium amortization from January 1, 2015, to July 1, 2015, is
P22,323. Since the purchase was made on March 31, 2015, then a portion of the
amount must have been amortized. Therefore, the carrying amount on March 31,
2015, is computed as follows:
Carrying amount, January 1, 2015 3,255,906
Less: Premium amortization from January 1
to March 31, 2015 (1/2xP22,323) 11,161
Carrying amount, March 31, 2015 3,244,745

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Since the purchase was made on March 31, 2015, the purchase price necessarily
includes accrued interest from January 1, 2015, to march 31, 2015. Thus, the total
purchase price is computed as follows:

Carrying amount, March 31, 2015 3,244,745

Add: Accrued interest from January 1 to March 31, 2015 60,000
Total purchase price on March 31, 2015 3,304,745

Market price of serial bonds

Face amount 6,000,000
Annual installment every December 31 2,000,000
Date of issue January 1, 2015
Nominal interest rate payable annually every Dec. 31 12%
Effective interest rate 14%

The market price of the bonds is equal to the present value of the principal plus the
present value of future interest payments using the effective rate.
The present value of 1 at 14% is as follows:
One period 0.8772
Two periods 0.7695
Three periods 0.6750
The simple approach is to compute the present value of the cash flows from the
bonds.
Principal due on December 31, 2015 2,000,000
Interest received on 12/31/2015 720,000
Total cash flows-December 31, 2015 2,720,000

Principal due on December 31, 2016 2,000,000

Interest received on 12/31/2016 (4,000,000x12%) 480,000
Total cash flows-December 31, 2016 2,480,000

Principal due on December 31, 2017 2,000,000

Interest received on 12/31/2017 (2,000,000x12%) 240,000
Total cash flows- December 31, 2017 2,240,000
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Accounting for Investments in Equity and Debt Instruments

The purchase price or market price of the serial bonds is computed by multiplying
the total cash flows every December 31 by the relevant present value factor.

December 31, 2015 (2,720,000x.8772) 2,385,984

December 31, 2016 (2,480,000x.7695) 1,908,360
December 31, 2017 (2,240,000x.6750) 1,512,000
Total market price 5,806,344

Glossary
Effective interest method: Accounting method for discounting bonds.
Discount: Effective rate is higher than the nominal rate
Premium: Effective rate is lower than the nominal rate.

References and Supplementary Materials

Books and Journals
1. Cabrera, M. B., & Ocampo, R. R. (n.d.). Financial Accounting & Reporting - Standards &
Application (2014-2015 ed., Vol. 2). Manila, Philippines.
2. Robles, N. S., & Empleo, P. M. (2014). Intermediate Accounting (2014 ed., Vol. 1).
Manila, Philippines.
3. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
2).Manila, Philippines.
4. IFRS 9, Financial Instruments
5. IAS 39, Financial Instruments: Recognition and Measurement
6. IAS 32 Financial Instruments: Presentation

Online Supplementary Reading Materials

1. Debt Financing; http://open.lib.umn.edu/financialaccounting/chapter/14-1-debt-
financing/; October 23, 2017
2. The Issuance of Notes and Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-2-the-issuance-of-notes-
and-bonds/; October 23, 2017
3. Accounting for Zero-Coupon Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-3-accounting-for-zero-
coupon-bonds/; October
4. Pricing and Reporting Term Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-4-pricing-and-reporting-
term-bonds/; October 23, 2017
5. Issuing and Accounting for Serial Bonds;
http://open.lib.umn.edu/financialaccounting/chapter/14-5-issuing-and-accounting-
for-serial-bonds/; October 23, 2017
Course Module
6. Bonds with Other Than Annual Interest Payments;
http://open.lib.umn.edu/financialaccounting/chapter/14-6-bonds-with-other-than-
annual-interest-payments/; October 23, 2017
Online Instructional Videos
1. Effective Annual Interest Rate;
http://www.investopedia.com/terms/e/effectiveinterest.asp; October 23, 2017