Effective Interest Method

Effective Interest Method

- The method to be used if the problem is silent
- Can only be used if there is effective interest rate
EFFECTS OF AMORTIZATION
1. IF THERE IS PREMIUM ON BONDS
• The interest income every year decreases
• The amortization every year increases
• The nominal rate is greater than the effective rate
2. IF THERE IS DISCOUNT ON BONDS
• The interest income every year increases
• The amortization every year increases
• The nominal rate is less than the effective rate
Note: Whether discount or premium, the amortization every year will increase
because the difference between the interest income and interest received will
increase.
 Subsequent Measurement
Sample Problem: On January 1, 2021, Fancy Company acquired P1,000,000 12% bonds to be held as financial assets at amortized cost
for Interest is payable annually on December 31. The bonds mature on January 1, 2024.
The effective interest method of amortization is used. The bonds have a 10% effective yield.
Initial recognition = Present value of future cash flows
Initial recognition = Present value of Principal payment + Present value of interest payment

Present value of principal payment = Principal payment x Present value factor Present value of Principal payment 751,000
1,000,000 x 0.75 = 751,000 Add: Present value of Interest payment 298,440
Present value
1 of interest payment = Interest Payment x Present value factor Total present value 1,049,440
1,000,000 x .12 = 120,000 x 2.48 = 298,440
7
Date Interest Received Interest Income Amortization Present Value
Jan. 1,2021 1,049,440
Dec.31,2021 120,000 104,944 15,056 1,034,384
Present Value
= Previous PV plus or minus Amortization
Interest Received Interest Income Amortization 1,049,440 – 15,056 = 1,034,384
= Face value x Nominal rate = Present value x Effective rate = Interest received less Interest Income OR
1,000,000 x 12% = 120,000 1,049,440 x 10% = 104,944 120,000 – 104,944 = 15,056 Present value – interest received + interest
income
Journal Entry Interest Income 15,056
1,049,440 – 120,000 + 104,944 = 1,034,384
Cash 120,000 Bonds Receivable 15,056
OR
Interest Income 120,000 Face value add Remaining premium
1,000,000 add (49,440 –15,056) = 1,034,384
Note: If the bonds has premium, the amortization is deducted to the present value.
Subsequent Measurement
Sample Problem: On January 1, 2021, Fancy Company acquired P1,000,000 12% bonds to be held as financial assets at amortized cost
for Interest is payable annually on December 31. The bonds mature on January 1, 2024.
The effective interest method of amortization is used. The bonds have a 10% effective yield.

Date Interest Received Interest Income Amortization Present Value

Jan. 1,2021 1,049,440
Dec.31,2021 120,000 104,944 15,056 1,034,384
Dec.31,2022 120,000 103,438.4 16,561.6 1,017,822.4

Interest Received(2022) Interest Income(2022) Amortization(2022)

= Face value x Nominal rate = Present value x Effective rate = Interest received less Interest Income
1,000,000 x 12% = 120,000 1,034,384 x 10% = 103,438.4 120,000 – 103,438.4= 16,561.6
Present Value
Journal Entry Interest Income 16,561.6 = Previous PV plus or minus Amortization
Cash 120,000 Bonds Receivable 16,561.6 1,034,384 – 16,561.64 = 1,017,822.4
Interest Income 120,000 OR
Present value – interest received + interest
Note: The amortization increases every year whether there is premium or discount income
The interest income decreases every year if there is premium 1,034,384 – 120,000 + 103,438.4 = 1,017,822.4
OR
Face value add remaining premium
1,000,000 + (49,440 – 15,056 – 16,561.6 )
= 1,017,822.4
Subsequent Measurement
Sample Problem: On January 1, 2021, Fancy Company acquired P1,000,000 12% bonds to be held as financial assets at amortized cost
for Interest is payable annually on December 31. The bonds mature on January 1, 2024.
The effective interest method of amortization is used. The bonds have a 10% effective yield.

Date Interest Received Interest Income Amortization Present Value

Jan. 1,2021 1,049,440
Dec.31,2021 120,000 104,944 15,056 1,034,384
Dec.31,2022 120,000 103,438.4 16,561.6 1,017,822.4
Dec.31,2023 120,000 102,177.6 17,822.24 1,000,000

Interest Received(2023) Interest Income(2023) Amortization(2023)

= Face value x Nominal rate = Present value x Effective rate = Interest received less Interest Income
1,000,000 x 12% = 120,000 1,017,822.4 x 10% = 101,782.24 but we 120,000 – 102,177.6 = 17,822.24 Present Value
will use 102,177.6 to make the PV = Previous PV plus or minus Amortization
Journal Entry equal to the face value Interest Income 17,822.24
1,017,822.24 - 17,822.24 = 1,000,000
Cash 120,000 Bonds Receivable 17,822.24
OR
Interest Income 120,000 Balance of Premium = 49,440 – 15,056 Present value – interest received + interest
– 16,561.6 Cash 1,000,000 income
= 17,822.24 Bonds Receivable 1,000,000 1,017,822.4– 120,000 + 102,177.6 =1,000,000
OR
Face value + premium
1,000,000 - (49,440 – 15,056 – 16,561.6 – 17,822.24)
= 1,000,000
Short Cut Computation
Sample Problem: On January 1, 2021, Fancy Company acquired P1,000,000 12% bonds to be held as financial assets at amortized cost
for Interest is payable annually on December 31. The bonds mature on January 1, 2024.
The effective interest method of amortization is used. The bonds have a 10% effective yield.
Date Interest Received Interest Income Amortization Present Value
Jan. 1,2021 1,049,440
Dec.31,2021 120,000 104,944 15,056 1,034,384
Dec.31,2022 120,000 103,438.4 16,561.6 1,017,822.4
Dec.31,2023 120,000 102,177.6 17,822.24 1,000,000

SHORT CUT FORMULA

Present value of Principal payment
Add: Present value of Interest payment
Total present value

Present value at the end of 2021

Present value of Principal payment 1,000,000 x 0.826 = 826,400 Present value at the end of 2022
Add: Present value of Interest payment 120,000 Present value of Principal payment 1,000,000 x 0.909 = 909,000
x 1.736 = 208,320 = 109,080
Total present value Add: Present value of Interest payment 120,000 x 0.909
1,034,720 Total present value 1,018,080

Note: The shortcut uses the same principle of computing the present value at the initial recognition, count the number of
years before the entity can received the cash and then use it in getting the present value factor