Business Finance
Annuities and Bonds

Question Description

Compare and contrast the straight line method and the effective interest rate method of amortization. Defend or critique FASB’s position on the reasons why the effective interest rate method is the preferred method for amortizing a discount or premiu

Final Answer

Comparison of Amortization Methods

Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases. Under the straight-line method the interest expense remains at a constant annual amount even though the book value of the bond is decreasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant.

Notice that under both methods of amortization, the book value at the time the bonds were issued ($104,100) moves toward the bond's maturity value of $100,000. The reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.

Reference:

http://www.accountingcoach.com/bonds-payable/explanation/8


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