When bonds are sold at a discount or a premium, the interest rate is adjusted from the face rate to an effective rate that is close to the market rate when the bonds were issued. Therefore, bond discounts or premiums have the effect of increasing or decreasing the interest expense on the bonds over their life. Under these conditions,it is necessary to amortize the discount or premium over the life of the bonds by using either the straight-line method or the effective interest method.
The straight-line method allocates a fixed portion of the bond discount or premium each interest period to adjust the interest payment to interest expense.
The effective interest method, which is used when the effects of amortization are material, results in a constant rate of interest on the carrying value of the bonds. To find interest and the amortization of discounts or premiums, the effective interest rate is applied to the carrying value of the bonds (face value minus the discount or plus the premium) at the beginning of the interest period. The amount of the discount or premium to be amortized is the difference between the interest figured by using the effective rate and that obtained by using the face rate.
