DISCOUNT AND PREMIUM ON BONDS PAYABLE

Under PFRS 9, using the effective interest method or scientific method or simply known "interest method" is required in the amortization of discount on bonds payable, premium on bonds payable and bond issue cost.

This method differentiate two kinds of interest rate, namely the nominal rate known as coupon or stated rate and effective rate known as the yield rate or market rate.

The effective rate is the rate that exactly discounts estimated cash future payments through the expected life of the bonds payable or when appropriate, a shorter period to the net carrying amount of the bonds payable.

When bonds are sold at face value, the effective rate and the nominal rate are the same. But when bonds are sold at a premium, the effective rate is lower than the nominal rate. And when the bonds are sold at a discount, the effective rate is higher than the nominal rate.

Under this method, the effective interest expense is computed by multiplying the effective rate by the carrying amount of the bonds. The carrying amount of the bonds changes every year as the amount of premium or discount is amortized periodically.

Under the effective amortization of discount, the interest expense is higher than the interest paid. The difference between the interest expense and interest paid is the discount amortization which is added in the carrying value or amount of the bonds.

While, the effective amortization of premium, the interest expense is lower than the interest paid. The difference between the interest paid and interest expense is the premium amortization which is deducted in the carrying value or amount of the bonds.

Interest expense is determined by multiplying the effective interest rate by the carrying amount of the bonds. Interest paid is computed by multiplying the nominal rate by the face value of the bonds. Actually, it can be presented using the schedule of amortization table.

The market price or issue 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.

The present value of the principal bond liability is equal to the face value of the bond multiplied by the present value of 1 factor at the effective rate for a number of interest periods.

The present value of the future interest payments is equal to the periodic nominal interest multiplied by the present value of an ordinary annuity of 1 factor at the effective rate for a number of interest periods.

Under bond issue cost, PFRS 9 provides that "transaction costs" that are directly attributable to the issue of a financial liability shall be included in the initial measurement of the financial liability.

Transaction costs are defined as fees and commissions paid to agents, advisers, brokers and dealers, levies by regulatory agencies and securities exchange, and transfer taxes and duties. Clearly, transaction cost include bond issue costs.

Bond issue costs will increase discount on bonds payable and will decrease premium on bonds payable.

Under the effective interest method, bond issued cost must be "lumped" with the discount on bonds payable and "netted" against the premium on bonds payable.

The effective rate cannot be computed algebraically but by means of trial and error or the "interpolation process".

The calculation of the effective rate requires the use of mathematical table of present value of a single payment and present value of an ordinary annuity. Actually, the effective rate can easily be determined through the use of a financial calculator.

Reference: Financial Accounting Volume 2 2012 edition - Effective Interest Method by Conrado T. Valix, et. al