Effective Interest Method PDF

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EFFECTIVE INTEREST METHOD: Amortized Cost, FVOCI & FVPLTwo kinds of interest rate: Nominal Rate – coupon rate/stated rate Effective rate – yield rate/market rate which is the actual or true rate of interest EFFECTIVE INTEREST METHOD Simply requires the comparison between interest earned/inte...

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INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY EFFECTIVE INTEREST METHOD: Amortized Cost, FVOCI & FVPL

Two kinds of interest rate: 1. Nominal Rate – coupon rate/stated rate 2. Effective rate – yield rate/market rate which is the actual or true rate of interest EFFECTIVE INTEREST METHOD • • • •

Simply requires the comparison between interest earned/interest income & interest received IE/II – IR = Premium amort. or Discount amort. IE/II = effective rate x carrying amount IR = nominal rate x face amount

Cost = Face Value Bond Premium

Effective rate vs Nominal Rate ER=NR ERNR

Because discount is a gain on the part of the bondholder

EIM - Discount On January 1, 2019, an investor acquired 1,000,000 face amount bonds dated January 1, 2019. The bonds mature on December 31, 2020. The life of the bonds is 2 years and 8% interest is payable semiannually on June 30 and December 31. The cost of the bonds is 964,540, a price which yield a 10% effective rate per year. Schedule of Amortization Date Interest received Jan. 1, 2019 Jun. 30,2019 Dec. 31, 2019 Jun. 30 2020 Dec. 31, 2020

40,000 40,000 40,000 40,000

Interest income

48,227 48,638 49,070 49,525

✓ IR = 1M x 4% = 40T ✓ II = 964,540 x 5% = 48,227 ✓ Discount Amortization = 48,227 – 40T = 8,227 ✓ CA = 964,540 + 8,227 = 972,767 2019 Jan. 1 Investment in Bonds 964,540 Cash 964,540 Acquisition of the bonds.

Discount amortization 8,227 8,638 9,070 9,525

Carrying amount 964,540 972,767 981,405 990,475 1,000,000

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY Jun. 30 Cash 40,000 Interest Income 40,000 Semiannual interest received. Jun. 30 Investment in Bonds 8,227 Interest Income 8,227 Amortization of discount for 6 months. Dec. 31 Cash 40,000 Interest Income 40,000 Dec. 31 Investment in Bonds 8,638 Interest Income 8,638 Amortization of discount for the last 6 months. NOTE: Amortization is done on every interest date.

EIM – Premium On January 1, 2019, an investor acquired 1,000,000 face amount bonds dated January 1, 2019. The bonds mature on December 31, 2021. The bonds mature in 3 years and bear 12% interest payable annually every December 31. The cost of bonds is 1,049,740, a price which will yield an effective interest of 10%. Schedule of Amortization Date Interest received Jan. 1, 2019 Dec. 31,2019 Dec. 31, 2020 Dec. 31, 2021

120,000 120,000 120,000

Interest income

Premium amortization

104,974 103,471 101,815

15,026 16,529 18,185

✓ IR = 1M x 12% = 120T ✓ II = 1,019,740 x 10% = 104,974 ✓ Premium Amortization = 48,227 – 40T = 8,227 ✓ CA = 1,049,740 – 15,026 = 1,034,714 2019 Jan. 1 Investment in Bonds 1,049,740 Cash 1,049,740 Dec. 31 Cash 120,000 Interest Income 120,000 Dec. 31 Interest Income 15,026 Investment in Bonds 15,026 2020 Dec. 31 Cash 120,000 Interest Income 120,000 Dec. 31 Interest Income 16, 529 Investment in Bonds 16,529

Carrying amount 1,049,740 1,034,714 1,018,185 1,000,000

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY

Face amount of bonds Acquisition cost Premium of the bonds Annual installment on Dec. 31, 2019 and every Dec. 31 thereafter Date of issue Nominal interest rate payable annually every Dec. 31 Effective interest rate Schedule of amortization Date Interest received 1/1/2019 12/31/2019 400,000 12/31/2020 300,000 12/31/2021 200,000 12/31/2022 100,000

EIM – Serial Bonds 4,000,000 (4,171,810) 171,810 1,000,000 Jan. 1, 2019 10% 8% Interest income

Premium amortization

Principal payment

333,745 248,444 164,320 81,681

66,255 51,556 35,680 18,319

1,000,000 1,000,000 1,000,000 1,000,000

Carrying amount 4,171,810 3,105,555 2,053,999 1,018,319 -

✓ IR = 4,000,000 x 10% = 400,000 (2019) = 3,000,000 x 10% = 300,000 (2020) ✓ II = 4,171,810 X 8% = 333,745 ✓ PA = 400,000 – 333,745 = 66,255 ✓ CA = 4,171,810 – 1,000,000 – 66,255 = 3,105,555 2019 Jan. 1 Investment in Bonds 4,171,810 Cash 4,171,810 Dec. 31 Cash 1,400,000 Investment in Bonds 1,000,000 Interest Income 400,000 Dec. 31 Interest Income 66,255 Investment in Bonds 66,255

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Bond Investment – FVOCI – when the business model includes selling the financial asset in addition to collecting contractual cash flows. Bond Investment - FVOCI

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY On January 1, 2019, an entity purchased bonds with face amount of 5,000,000 for 4,760,000 including transaction cost 160,000. The business model is to collect contractual cash flows and to sell the financial asset. The bonds mature on December 31, 2021 and pay 10% interest annually on December 31 with 12% effective yield. Financial asset – FVOCI 4,760,000 Cash 4,760,000

To record annual interest received (Dec. 31) Cash (10% x 5M) 500,000 Interest Income 500,000 Accordingly, this would require amortization of any discount or premium on the bond investment: Face amount Acquisition cost Discount

5,000,000 (4,760,000) 240,000

Amortization of discount on Dec. 31, 2019 Financial asset – FVOCI Interest Income

71,200 71,200

Date

Interest received

Interest income

Discount amortization

1/1/2019 12/31/2019 12/31/2020 12/31/2021

500,000 500,000 500,000

571,200 579,744 589,056

71,200 79,744 89,056

Carrying amount 4,760,000 4,831,200 4,910,944 5,000,000

The bonds are quoted at 102 on December 31, 2019 Financial asset – FVOCI Unrealized gain - OCI

268,800 268,800

Market value 12/31/19 (5M x 102%) Carrying amount – 12/31/19 Unrealized gain – OCI

5,100,000 (4,831,200) 268,800

NOTE: discount amortization must still be in accordance with the effective interest table of amortization regardless of the change in market value.

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY 2020 The market value is 105 and the bonds are sold on June 30, 2021 at 110 plus accrued interest 1. Record interest received

Cash

500,000 Interest Income

500,000

2. Record the discount amortization Financial asset – FVOCI Interest Income

79,744 79,744

3. Record the change in market value Financial asset – FVOCI Unrealized gain - OCI Market value 12/31/20 (5M x 105%) Investment bal – 12/31/20 (5.1M + 79,744) Unrealized gain – OCI

5,250,000 (5,179,744) 70,256

70,256 70,256

OTHER COMPUTATION: Market value - 12/31/20 CA per table – 12/31/20 CUMULATIVE Unrealized gain – 12/31/20 Unrealized gain = 12/31/19 Increase in unrealized gain

5,250,000 (4,910,944) 339,056 (268,800) 70,256

2021 (…bonds are sold on June 30, 2021 at 110 plus accrued interest.) 1. Record discount amortization from January 1 to June 30, 2021 Financial asset – FVOCI Interest Income

44,528 44,528

2. Record the sale of bonds on June 30, 2021 Cash 5,750,000 Unrealized Gain – OCI 339,056 Financial asset – FVOCI Gain on sale of FA Interest Income Sale Price (5M x 110) Unrealized gain – OCI Total Investment bal per book – 06/30/21 (5,250,000 + 44,528) Gain on sale of FA

5,500,000 339,056 5,839,056 (5,294,528) 544,528

OTHER COMPUTATION: Sale price CA per table – 06/30/21 (4,910,944 + 44,528) Gain on sale of FA

Sale price Interest accrued from Jan. 1 to June 30, 2021 (5M x 10% x 1/2) Total cash received

5,294,528 544,528 250,000

5,500,000 (4,955,472) 544,528

5,500,000 250,000 5,750,000

NOTE: The cumulative gain or loss previously recognized in OCI is reclassified to profit or loss on disposal of the investment

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY • Fair value option – investment in bonds can be designated without revocation as measured at fair value through profit or loss even if the bonds are held for collection as a business model - All changes in fair value are recognized in profit or loss. Accordingly, any transaction cost incurred is an outright expense. - The interest income is based on the nominal interest rate rather than effective interest rate. on January 1, 2019, an entity purchased bonds with face amount of 5,000,000 for 5,400,000 plus broker commission of 100,000 The stated interest rate is 8% payable annually every December 31 with effective interest rate of 6% On December 31, 2019, the bonds had a fair value of 5,600,000 2019 1. Financial asset – FVPL 5,400,000 Commission expense 100,000 Cash 5,500.000 2. Cash (8% x 5M) 400,000 Interest Income 400,000 3. Financial asset – FVPL 200,000 Gain from changes in FV 200,000 (5.6M – 5.4M)

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Market price of bonds - is equal to the present value of the principal plus the present value of future interest payments using the effective interest rate. DISCOUNT

Face amount of bonds Date of issue of bonds Nominal rate Effective rate Interest payable annually Date of maturity

3,000,000 Jan. 1, 2019 6% 8% December 31 Dec. 31, 2021

The present value of an ordinary annuity of 1 is determined for the number of interest periods using the effective rate The relevant present values are: PV of an ordinary annuity of 1 at 8% for three periods 2.58 PV of 1 at 8% for three periods 0.79 PV of principal (3M x .79) PV of future interest payments (180T x 2.58) Market price of bonds

2,370,000 464,400 2,834,400

Annual nominal interest payment (6% x 3M)

180,000

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY NOTE: The effective interest rate is higher than the nominal interest rate, thus: Face amount PV or market price of bonds Discount

Face amount of bonds Date of issue of bonds Nominal rate Effective rate Semiannual interest Date of maturity

3,000,000 2,834,400 165,600

PREMIUM 3,000,000 Jan. 1, 2019 8% 6% June 30 & Dec. 31 Dec. 31, 2020

The present value of ordinary annuity of 1 is determined for the number of interest periods using the effective rate The relevant present values are: PV of an ordinary annuity of 1 at 3% for four periods 3.72 PV of 1 at 3% for four periods 0.89 PV of principal (3M x .89) PV of future interest payments (120T x 3.72) Market price of bonds

2,670,000 446,400 3,116,400

Semiannual nominal interest payment (4% x 3M)

120,000

NOTE: The effective interest rate is lower than the nominal interest rate, thus: Face amount PV or market price of bonds Premium

3,000,000 3,116,400 166,400

Face amount Annual installment every Dec. 31 Date of issue Nominal interest rate payable annually every Dec. 31 Effective interest rate PV of 1 at 14% One period Two periods Three periods

SERIAL BONDS 6,000,000 2,000,000 Jan. 1, 2019 12% 14%

0.877 0.770 0.675

Simple approach is to compute the PV of the cash flow from the bonds

INTERMEDIATE ACCOUNTING VOL. 1 VALIX: CHAPTER 20 SUMMARY Principal due on 12/31/19 2,000,000 Interest Received on 12/31/19 (6M x 12%) 720,000 Total cash flow 12/31/19 2,720,000 Principal due on 12/31/20 2,000,000 Interest Received on 12/31/20 (4M x 12%) 480,000 Total cash flow 12/31/20 2,480,000 Principal due on 12/31/21 2,000,000 Interest Received on 12/31/21 (2M x 12%) 240,000 Total cash flow 12/31/21 2,240,000

12/31/19 (2,720,000 x .877) 12/31/20 (2,480,000 x .770) 12/31/21 (2,240,000 x .675) Market price of serial bonds

2,385,440 1,909,600 1,512,000 5,807,040...