CFA Level 1

Liabilities - Total Interest Cost Components


Total interest expense, which is reported on the income statement, includes the total coupon payment plus a portion of the underappreciated discount or premium for the specified accounting period.

U.S. GAAP allows companies to amortize premiums or discounts by utilizing a straight-line amortization or the effective interest rate method.
  • Straight-line Depreciation
Formula 9.2
Depreciation amount = premium or discount at issue
payment periods
Example
Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation. The company issues at $1,038,609 and face value is $1m.

Interest expense = coupon payments - unamortized portion of bond premium for the period

The carry value = total market value at time of issue - cumulative amortized premium or discount

Unamortized portion of bond premium for every period (six months in this example) = $38,609 / (10 payment periods) = $3,860.9
Result
Under this method the issuing company will recognize an equal amount of unamortized depreciation for every period.
  • Effective Interest Rate Method
    Effective interest rate method results in an interest expense that is a constant percentage of the carrying value of the bonds; thus interest expense varies from period to period. In contrast, the straight-line method results in a constant interest expense from period to period.
Formula 9.3
Interest expense = current interest rate at time of issue x carry value

The carry value = total market value at time of issue - cumulative amortized premium or discount
Formula 9.4
Amortized premium (discount) = coupon payment - interest expense

Example
Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years, and similar bonds are paying 10%. Bond premiums are amortized using the effective interest rate depreciation method. The company issues at $1,038,609 and face value is $1m.





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