Annual Straight Line vs. Effective Interest Amortization
Original post by David Ingram of Demand Media
Annual straight-line amortization and effective-interest amortization are accounting techniques used to account for the value of bonds payable in specific situations. The bonds payable account represents the value of outstanding bonds on which a company is making interest payments and eventual repayments of principle. Amortization comes into play when the value in the bonds payable account does not match the value of cash received from selling a bond, requiring accountants to gradually alter the balances of several accounts to reflect the true financial impact of the bond on the company.
When a company sells a bond for less than or more than its face value, it is selling the bond at a discount or a premium. When a company sells a bond at a discount or premium, accountants make entries to three separate accounts: one to bonds payable for the face value of the bond, one to cash for the discounted or additional amount received for the bond and one to bond discount or bond premium to account for the difference between the face value and the amount received. Bond amortization is a method of reconciling the balances in the discount and premium accounts with the amount paid out for the bonds by adding or subtracting the discount or premium from the interest expense account. Annual straight-line amortization and effective-interest amortization are two options for amortizing bond premiums or discounts.
Annual Straight-Line Amortization
Using the straight-line amortization method, accountants transfer an equal amount from the bond discount or premium account over to the interest expense account each payment period. For bond discounts, accountants add onto the interest expense balance each month, to account for the additional expense of selling a bond at a discount and repaying it at face value. For premiums, accountants subtract from the interest expense account as they reduce the credit balance in the premium account, to account for the extra income from selling a bond for more than the amount the company will repay. To determine the amount to amortize each payment period under the straight-line method, divide the total amount of bond premium or discount by the number of payment periods in the life of the bond, and use the same amount for each period.
Rather than assigning an equal amount of amortization per period, the effective-interest method calculates different amounts to transfer to interest expense each period. Although the company will make regular, equal interest payments each period, it will record different amounts in the interest expense category under the effective-interest method. To determine the amount to assign to interest expense each period under this method, multiply the effective interest rate (annual interest rate / number of payment periods per year) by the current book value of the bond.
Advantages of Each
Straight-line amortization has the advantage of being a simpler and more straightforward method. The straight-line method can be better suited for smaller companies with leaner accounting departments, allowing accountants to calculate amortization more quickly. However, accounting software packages and free online amortization calculators can eliminate this advantage, as they can calculate amortization using any method instantly. Effective-interest amortization gains an advantage by reducing the amount of bond discount or premium by a smaller amount each period, arriving at the same end result but showing a more realistic picture of the bond's value to the company at different points throughout the repayment period.
- Accounting Coach; Amortizing Bond Discount with the Effective Interest Rate Method; Harold Averkamp
- Accounting Scholar: Straight-Line Amortization Method of Bonds Payable
About the Author
David Ingram has written for multiple publications since 2009, including "The Houston Chronicle" and online at Business.com. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law. He has earned a Bachelor of Arts in management from Walsh University.