effective-interest amortization

When a bond is sold at a discount or premium, the difference between the cash received and the face value has to be spread out over the bond's life rather than dumped into one year. The question is how to spread it. The effective-interest method answers this by tying each period's interest expense to the actual money the company effectively owes at that moment, giving a smooth, economically honest result.

Under effective-interest amortization, each period's interest expense equals the bond's carrying value at the start of the period multiplied by the market (effective) interest rate. The cash interest paid still equals the face value times the coupon rate. The difference between these two numbers is the amount of discount or premium amortized that period. For a discounted bond, expense is larger than cash paid, so the extra increases the carrying value toward face value; for a premium bond, expense is smaller than cash paid, so the difference shrinks the carrying value toward face value. Because the carrying value changes each period, the interest expense changes too — it is not a flat figure.

Effective-interest amortization matters because it is the method required under both US GAAP and IFRS for material amounts, since it reflects a constant true interest rate on the actual obligation. Its main alternative, the straight-line method, simply spreads the discount or premium in equal slices each period — easier to compute but less accurate, and acceptable only when the difference from effective interest is immaterial. Effective interest produces a changing expense each year; straight-line produces the same expense every year.