Effective Interest Amortization of Bond Premium or Discount - Online Tutor, Practice Problems & Exam Prep

The effective interest method for amortization of bond premiums or discounts involves calculating the bond's carrying value, interest expense, and cash payments. The interest expense is derived from the bond's carrying value multiplied by the market interest rate, while cash payments are based on the principal and stated interest rate. The difference between these amounts represents the amortization of the discount or premium. This method aligns with GAAP, ensuring accurate financial reporting and reflecting the true cost of borrowing over time.

Calculating Bond Price with Time Value of Money

Alright. So this is about as tough as this course can get. It's the effective interest method of amortization for the bond premium or discount. Okay? That's a lot of words. The effective interest method for the amortization of bond premium or discount. Let's check it out. So first thing I wanted to review with you is the relationship between the stated rate of the bond and the market rate on other similar bonds. Okay? So, if the stated rate of a bond, let's say, is 10% and the market rate is 10%, well, the price of the bond today when we sell it, is going to be equal to the face value. Okay? Just like we've been discussing. The stated rate and the market rate, well, if the stated rate, let's say, is 8% and the market rate is 10%, the price of the bond is going to be less than the face value. Right? And if the stated rate is greater than market rate, so 12% stated rate, 10% market rate. Well, now, the price of the bond will be greater than face value. Now, if you're still struggling with that, I suggest going back to the previous videos and studying again the discounts and the premiums and those journal entries because it's about to get a little more complicated with the effective interest method, okay? Because now what we're gonna use is we're gonna use those time value of money concepts that we learned previously, We're going to start applying those to the value of these bonds. So let's check out this example here. On January 1, 2018, ABC Company issues $100,000 of 9% bonds maturing in 5 years. Interest is payable semi-annually on January 1st and July 1st. The market interest rate was equal to 10%. So notice they tell us 9% is the stated rate of these bonds and 10% is the market rate. So what does that tell us? Do you think we're going to have a discount or a premium? We're going to have a discount, right? The stated rate. We're saying, "Hey, look, we've got 9% bonds over here, but everyone else is offering 10%." Investors would rather earn 10% interest, so they would pay more for the 10% interest bonds than they would for ours. Ours are going to sell at a discount, right? Because we're offering less interest. But notice, in this example, they didn't give us a percentage. They didn't sell it. They didn't say these bonds sold at 94. These bonds sold at 96. They didn't tell us what the price was. What they want us to do is use our present value tables. We want to use our present value tables for the present value of a dollar and the present value of the annuity of $1 to find out what the price of the bond is today, okay? So remember the price of a bond, the real way that we know what the price of a bond is, is by finding out what is the value today of all of those interest payments we're going to receive in the future and what is the value of that final principal payment that we're going to receive at the end? How much is that worth to me today? Well, that's the price of the bond, okay? So let's go ahead and let's draw a timeline here like we did when we learned time value of money. And if this starts to look a little hairy to you, I suggest going and reviewing time value of money as well. Because like I said, this is about as complicated as this class is going to get. Alright? So what we want to do, remember, there's going to be a 5 year bond, but this is going to be a 5 year bond and paying semi-annual interest. So there's going to be instead of 5 periods, there's gonna be 10 interest payments. Right? We're gonna pay interest 10 times, not 5 times. So we're gonna have 10 periods on our timeline here. So let's go ahead and break this up into the 10 periods, And I'll extend it here. 9 and then 10 out there, okay? So we've got our 10 periods on our timeline and that's the 10 interest payment period, right? Remember, 0 is right now and then we're gonna have interest payments at each period in the future. So you can imagine this is going to be right here. This first one, this is July 1, 2018. This is January 1st 2019, July 1st 2019, and so on. Right? All the way up until the interest, until the final payment on January 1, 2023, which is 5 years from now, okay? So what we need to do is we need to find out how much all the cash flows are going to be. Where are the cash flows that happen and how much are they going to be? So the first thing we want to know is the cash interest. So the cash interest is going to equal the $100,000 value of the bonds times the 9% stated rate. Right? That's going to be the yearly interest, but we're paying interest semi-annually. So instead of 9%, let me put 0.09. So since it's semi-annual, well, we need to divide by 2 just like we've been and 9,000 divided by 2 is 4,500 semiannually, right? Per semiannual period, that's the amount of cash interest that we're gonna pay. So we're going to have on our timeline, we're gonna have cash flows of 4,500 every semi-annual period for the next 10 semi periods, right? We're going to be paying out 4,500 in cash. That's a lot of 4,500 payments, but we got them all in there, okay? But is that all the cash flows? No, there's also the principal payment, right? There's going to be a principal payment of $100,000. Put that in a different color. $100,000 in the final year, right? As we make our final payment, well, we're also going to pay back all that principal. Okay? So now what we need to do to find the price of this bond today, well, we need to find the present value of all of these payments. So let me do it in a different color. So all of these right here, notice what they are. When we think about our time value of money, when we did time value of money, what did we call a stream of payments that happened in equal intervals? Equal amounts of payments at equal intervals were called an annuity, right? So this right here is the present value of an annuity, okay? And we can use our annuity table to find the present value of those interest payments. And how about this right here? It's a one-time payment. Well, this is a lump sum, right? We talked about a lump sum, so we need to find the present value of the lump sum and that's the present value of the principal payment at the end. And if we add these together, plus present value of interest payments plus present value of principal, okay? So what we need to do is we need to use our tables twice. We need to do one for the annuity of the interest and one for the lump sum of principal at the end, okay? So let's go ahead and find out what each of those are and we're going to use our tables. I've reprinted the tables. If you look a couple of pages ahead, we should have, the printed tables there that we're going to use to solve this equation. Okay? So remember, when we use those tables, we need to have a value for N and a value for R. So our value for N is going to be equal to the number of periods, which is 5 years times 2 periods per year since it's semi-annual, our N is going to be 10. Now what about our R? Remember, whenever we use our time value of money tables, we use the market interest rate. We don't use the stated rate, we use the market rate. And the market rate in this case was 10%, but we divide it by 2 because we're talking about semiannual periods. So we're going to look up 5%. This is the numbers that we need for our table. N equals 10 and R equals 5%. Okay? So if you remember, our formulas for present value of an annuity and present value of a lump sum, well, the present value of the annuity, well, that's just going to equal the 4,500, right? The amount of the annuity payment, 4,500 times the present value factor. So let's go find what the present value factor is for an annuity of 10 periods, 5 percent. Okay. So let's go ahead and go to our present value table, 2 pages down and which table are we gonna use? Are we gonna use the top table present value of $1 or present value of ordinary annuity of $1? We're gonna use this bottom table, right? Ordinary annuity of $1 and what were our things? We had 5% for 10 periods. So this is our number, 7.722. Okay, that is our present value factor. Let's bring that up here. So our present value factor is 7.722, 4,500 times 7.722. What does that equal right here? Let me scroll up so you see the timeline. Let me get out of the way just make sure we see everything there. Okay. So 4,500 times 7.722, well, that comes out to 34,749. Okay. That is the present value of our annuity. That is the present value of the interest payments. We're not done yet. We need the present value of the lump sum, right? This is the principal payment that's happening in the final year. Well, we need to take that 100,000 times the present value factor, Okay? So in this case, it's gonna be the 100,000 times. Now we've done the hard work of finding our N and our R already. So let's go back to the table, and which table are we going to use this time? The top one or the bottom one? We're going to use the top one, right? Because now we're doing a lump sum. The present value of $1; that's the lump sum table. So we're going to have 10 periods, 5%, and let's find what that is there. 0.614. So that's what we need to bring to our table or to our formula here. 0.614 and that's gonna come out to 61,400. Okay? So all the hard work is behind us. Now all that's left to do is find the present value of the price of the bond. The price is gonna equal the sum of these 2. 34,749 plus 61,400 that comes out to $96,149 that is the present value of the bond. That was a lot tougher, right? But in the end, I showed you a lot of steps here. But in the end, what did we do? We took the interest payment, 4,500 per period times the present value factor. So we needed to find this N and the R, and then we do the 4,500 times the factor from the annuity table. And then we find the lump sum. We know that the principal value is 100,000 and then we find the present value factor using those same N and R in our present value table for lump sums, okay? Take those two numbers and add them together and that is the price today. And just like we expected, we got a price, 96,149 that was less than face value, right? The stated rate of the bond was 9% and the market rate was 10%, so it sold at a discount. And this is the exact amount that it would sell for, $96,149. So now we can make our journal entry where we debit cash. We know how much we're going to receive, 96,149. We're going to credit bonds payable, and how much do we credit bonds payable for? The full 100,000, right? Just like we have done every other time, the entire amount. And guess what? The difference is going to be our discount. Discount. Discount on bonds payable is going to be this difference. So let's find out what that is. 100,000 minus 96,149. Well, that comes out to $3,851, okay? So our discount on bonds payable is $3,851. Cool? Let's pause here and you might want to even rewind that to get a real good grasp of how we came up with that discount on bonds payable. And then let's move on to how we're going to actually amortize this discount using the effective interest method. Alright? Let's do that in the next video.

Important Equations for the Effective Interest Method of Bond Amortization

Alright. So, here I have listed some really important formulas that you're going to use when you do the effective interest method. Okay? If you get these down, then you're going to have no problem with this method. Alright? So the first thing you want to know is the bond's carrying value. The carrying value is the book value of the bond. Okay? So if we are going to release our balance sheet at any point in time, this is the amount that would show on the balance sheet. It would show the bonds payable account, which is the principal amount, right? There's going to be the principal in the bonds payable account, minus whatever discount or plus whatever premium. Just like we saw when we were studying discounts and premiums. Okay? So we need to know that bond carrying value. And we're going to use a table to keep track of it, but that's a very important part of the effective interest method: the bond's carrying value. Okay?

Then, each of our journal entries is going to have three parts. We're going to have the interest expense as a debit, we're going to have the cash payment as a credit, and then we're going to have the amortization of the discount or the premium. And that's going to depend on whether it's a discount or a premium, whether it's a debit or credit. But you should start to be familiar with that from our previous videos about that. So let's look at each of these formulas. Let's start with the interest expense. So we're taking the bond carrying value, right? What it's currently sitting at on our book, times the market interest rate and that is going to be our interest expense. That it will always be the debit to interest expense in this method. We're taking the carrying value times the market interest rate.

The cash interest payment, well that's going to be the principal amount of the bonds. So notice we're using both, we're first using the bond carrying value what it's worth on the books, but then for the cash payment, well that's always gonna be the principal amount just like we studied before times the stated interest rate. And I want to note, if we're doing semiannual payments, well, we're gonna have to divide these by 2, right? The stated interest rate would be half, the market interest rate would be half the amount as well, if those were semiannual periods. Okay?

And then finally, the amortization of the discount or the premium, that's gonna be the plug in this method. Okay? Before the plug was the interest expense when we did the straight-line method, well, the amortization is the plug in this method. Okay? So, we calculate our interest expense, we calculate our cash interest payment and then we subtract the two to see what's going to fill in this entry. So every time we do a journal entry for interest expense, we're always going to debit interest expense and we're gonna use that formula above and we're always gonna credit cash, right? And this cash could also be interest payable if we're going to pay it later, but 99% of the time we're going to see it as cash. You're going to pay it out as cash or it could be interest payable if we're going to pay the interest at a later date. Okay? And that's gonna be in both journal entries. We're always gonna have a debit to interest expense, whether it's a premium or a discount and a credit to cash. Okay? The difference is going to be in the discount or the premium, right? The amortization. So when it's a discounted bond, remember that discount had a debit balance, so we're going to use a credit to get rid of that debit balance. So the discount would be credited and it's always gonna be like this when we deal with these journal entries. So we would have some amount for interest expense, some credit to discounts on bonds payable, and some credit to cash. The opposite for premiums, right?

The premium has a credit balance, so to get rid of it, we need debits. So we would have a premium on bonds payable as an additional debit in these transactions, and we would have the credit to cash. Okay? So now we're going to take this onto a table and we're going to see how the interest expense changes every year and the amortization of the discount changes every year. But what's going to stay constant is the cash payment, right? We said, we have the principal amount and the stated rate, that's not changing. The carrying value that we use in the interest expense formula, that is changing as we go through, right? So that's going to affect our interest expense and then it's gonna affect our amortization of the discount or premium. Okay? So let's go ahead and apply these formulas to our example that we just calculated the price for, alright? Let's do that on the next page.

Effective Interest Method:Amortization Table

All right. So on the previous page, we calculated the beginning value of this bond. We've calculated the price and the amount of cash that we collected. So what we're going to do is use this table to calculate our interest expense each period, our cash, our amount that goes to the credit in the interest expense entry, and the amortization of that discount, okay? So let's go ahead and use that information to do this table here, okay? So remember, on January 1, 2018, that's when we sold the bond, right? It had a beginning value, as we saw, was 96,149. That's what we calculated, right? 96,149. Well, on that date, we don't pay any interest, nothing. The discount balance is going to be that full balance that we started with, 3,851, and we're going to have our ending carrying value as the same as the beginning at that point, right? There's no interest been paid yet, so we're going to have the 96,149 as the carrying value of the bond, okay? So remember, the interest payment, as time passes, we're going to start paying interest. And this is going to be the cash interest payment here. So remember, when we do this, it's going to be our principal amount times our stated rate and then we'll divide by 2 if it's semiannual. In this case, it was semiannual, right? It was a semiannual bond, as you can see right above, so we will divide by 2. So our principal was 100,000 times the 9% was our stated rate, 0.09 times, or excuse me, divided by 2, right? Because it is semiannual. So we will divide by 2, and this will give us our constant cash payment that we're going to make every period, right? Remember, the cash payment does not change in this case because it's always going to be the same stated rate and the same principal amount. 100,000 times 0.09 divided by 2, it's always going to be 4,500 will always be our cash payment of interest every period. Okay? So that's what we're going to put. Remember, now it's been half a year, so we're looking at July 1st, 2018. So we would have started the year with a beginning value in the bond of 96,149. We're going to pay cash interest of 4,500. Right? Now what about our interest expense? How did we say we're going to calculate that? That's going to be the carrying value of the bond times our market rate, and we'll divide by 2 if it's semiannual. And in this case, it is semiannual. So what are we going to do? We're going to take the carrying value times 0.10, right? It told us the interest rate on the market was 0.10, and then we are going to divide it by 2, okay? That is how we are going to calculate it in this case. Notice, I wrote carrying value because that's going to be changing every period, so we're going to have to do this calculation every period. So let's do it for this first period right here. What is going to be the interest expense? It's going to be the 96,149 times 0.1 divided by 2, and the interest expense comes out to be we're going to be rounding here every now and then, we don't want to have a bunch of decimals, so we're just going to keep the math simple. 4,807, right? And remember, the discount amortization, that's going to be the difference between the cash and the interest expense. Okay? And that's going to be changing from period to period as well. The cash minus the interest expense and don't worry about signs, if one's positive or one's negative. Remember, in a journal entry, we never have signs. We just have the number. So we'll do 4,807 minus 4,500 and we're going to get discount amortization of 307. So right here, these three numbers that we just calculated, that is our interest expense journal entry. We would debit interest expense for 4,807, credit cash for 4,500, and credit discount on bonds payable for 307. Okay? We'll see that down below. We'll get more into the journal entries, but let's go ahead and finish filling out this table using this method, okay? So how do we calculate the discount account balance? Well, it's going to be the previous balance minus amortization during the current period. So previous balance minus amortization will give us the new account balance. So 3,851 minus the 307, right? 3,851, well, we amortized 307 of that, so that's no longer part of the balance, and we're going to be left with 3,544, okay? So how do we get to the ending carrying value? Well, that's going to be the face value of the bond, minus the discount balance, right? Just like we saw when we did the straight line method, that face value minus the discount amount, it kept getting us to the carrying value, and just like we have in the formula above. So our face value is always going to be 100,000 in this example, right? And then we are going to subtract whatever the discount balance is. Okay? So we had the 100,000 in face value minus, in this case, 3,544. So 100,000 minus 3,544 gives us 96,456. So now the bond, if we're going to release our financial statements for July 1st, we would show a balance of 96,456 for these bonds, okay? So let's go ahead and fill in the rest of this table using the same logic. So we start at 96,456 for the next period, right? And we're going to have the same amount of cash interest. This will never change. Right? Because we had the same principal balance times the same stated rate divided by 2, that gives us 4,500 again. But now, what about our interest expense? Now, we're going to multiply 96,456. Our new carrying value, let me leave the formula on the screen there. Our carrying value of 96,456 times the 10% divided by 2, and that's going to give us our interest expense for this period of 4,823. Okay? So interest expense is now 4,823. So the difference between the two, 4,823 and 4,500, that comes out to 323. And there we go. This is our interest expense journal entry for the next period, right? So notice the interest expense journal entry changes every period. That's why this method is much more difficult than the straight line method. But this is the method that GAAP proposes. And the reason for it is because it more closely relates what you would have paid in interest had you used the market rate to start with. Okay? We don't need to go too much into the details other than how to calculate it here, okay? So this is the GAAP method. Let's go ahead and finish filling out this table. So the discount account balance, well, that's our previous balance of 3,544 minus 323, and that gets us to a balance of 3,221. Okay? So our face value of 100,000 minus the discount balance, notice that this keeps getting bigger as we get closer to our maturity date, and you can expect by maturity that it's going to be the full $100,000 balance. So our ending balance in that period is going to be the beginning balance in the next period, 96,779. Our cash interest stays the same, 4,500. Okay. Our interest expense, well, now it's going to be our new carrying value, 96,779 times 10% divided by 2, and we're going to get 4,839 as our interest expense in that period. The difference between the two, 339, and there is our interest expense journal entry for that period. Those three numbers. Cool? All right, let's keep it going. You can see that this is kind of just a flow now, right? 2,882 is going to be the balance here and 97,118. Right? We got that new discount balance by taking the previous 3,221 minus the 339, got us to the new balance, and then 100,000 minus that discount balance is our new carrying value. What I want you guys to do is pause right here, and I want you guys to finish filling out the table. And then come back and see if you did it correctly. So I'm going to wait 5 seconds while I wait for you to pause it and get guilty. And if you don't, you'll see me finish the table up, and you'll get no extra practice, alright? So I'm going to wait here. All right. I'm guessing you guys paused it, and now you're back and you're ready to finish up the problem. Let's go ahead and see how you did. Okay. So our new carrying value is going to be the 97,118 to start this period, and what do we got? 4,500, we're going to do 4,856, 356 for our discount amortization, and our discount account balance is going to be 2,526, right? If we subtract 100,000 minus 2,526, we're going to get 97,474. Now I want to make a note to you guys. If you guys were to see this on a test, I would not expect you to have to do this whole effective interest table for 10 payments, right? This would take forever. They would usually just ask you for the first few payments to make sure that you understand how this works, right? So let's keep going here and let's see how this finally finishes out. So 97,474 was our ending balance there, and then we're going to have the same 4,500. So what's going to be this one is 4,874, and notice how our interest expense keeps climbing throughout the period because our carrying value is higher each period. Okay? So 374, there's our interest expense journal entry. We're left with 2,152, which gives us an ending balance of 97,848. Okay? Let's go ahead and finish these up. So 97,848, guess what our cash interest is going to be? The same every period. Now, our interest expense, this period is 4,892. 392 in our amortization, leaving us with a balance of 1,760, which gives us an ending balance of 98,240, which is our beginning balance of the next period. And guess what? Cash interest is the same, and what is our amortization or our interest expense this period? 4,912. So 412 is our discount amortization, the difference between the two. There's our journal entry for interest expense. 1,348 is our discount balance after that amortization, which gives us an ending balance of 98,652. So notice how our ending balance has been increasing this whole time, right? Let me get out of the way here. Notice how the ending balance has been increasing this whole time because we're getting rid of the discount, right? We're amortizing the discount and it's increasing the ending carrying value of the bond as we reach maturity where it will equal 100,000. So 98,652 and our cash interest 4,500, 4,993 in interest expense, 433 will be our discount amortization leaving us with 915 here. In our discount account, 99,085. Alright. So we're almost done here. 99,085. So we're still paying 4,500 in interest cash. Our interest expense is now 4,954, which is 454 in discount amortization, leaving us with 461 in our discount account balance, leaving us at 99,539. And now I want to note something about the last period. In the last period, we need to get rid of the remaining discount balance, right? We have this much in our discount balance. Well, we're not going to do the same formula anymore. We just know that our discount needs to disappear. So that is going to be the amount of our discount amortization in the final period, 461. We know we're going to pay cash the same amount, 4,500. And now we're going to plug in our interest expense. That's just the 4,961, the sum of this and this together. Right? So we didn't really do the same exact formula in the final year because it's a plug to make sure that all of our numbers work out. We no longer have a discount balance, and we've got 100,000 as the carrying value of the bond. So now, it's the final day, it's maturity day, and the carrying value of the bond, 100,000, is equal to the face value of 100,000, the amount that we're going to pay back to the investors. That was a lot of work, right? There were a lot of number crunching that went on, and that's why they call us the crunching accountants here. Okay? So we just learned pretty much the hardest thing that you'll learn in this course. Let's go ahead and see how this translates to the journal entries in the next.

Effective Interest Method:Interest Expense Journal Entries

So once we've created our amortization table, building the journal entries is the easy part. We've already done all the hard work. Now we just take those numbers that we got in our amortization table and bring them down into our journal entries. So the July 1, 2018, journal entry, well those are going to be the numbers from July 1, 2018, in our amortization table. So July 1, 2018, here is our journal entry right here. We're going to debit interest expense for 4,807 just like it says in our table, 4,807. We're going to credit the discount on bonds payable for 307 and we're going to pay cash interest of 4,500, right?

Now, how about at the end of the year, December 31, 2018? So notice, we've got January 1, 2019, because that's the day we're actually going to pay it. But on the last day of the year, we are going to have to accrue for the interest that we have earned over the last 6 months, right? So on December 31, 2018, 6 months have passed and we're making our journal entry. So we would debit interest expense and that would be for the amount that we see there which was, I forgot, 4,0823. We would credit the discount on bonds payable for the 323 in the table, and, finally, instead of cash, in this case, remember we're accruing just like we did when we first learned our interest accruals. What we're not paying until tomorrow, until January 1, 2019, so we have an interest payable at this point. Okay? It could be cash if we're going to pay it today or interest payable if we're paying it tomorrow, right? 4,500, that's exactly what's happening here, okay?

And now on January 1, 2019, when we finally pay off that interest payable, what we would do interest payable for the 4,500 that we owe in cash and we're going to pay that in cash for 4,500, right? So that was just an adjusting entry really to make sure that we accrued for that interest expense that happened during those 6 periods or during those 6 months. And then finally, when we do pay it, we just get rid of that liability interest payable to pay for cash on the next day. Cool? Alright. So that's pretty tricky. I hope you guys understood that and if not, I know if you watch it one more time, you're going to get it. Alright? Let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What is the effective interest method for amortizing bond premiums or discounts?

The effective interest method for amortizing bond premiums or discounts involves calculating the bond's carrying value, interest expense, and cash payments. The interest expense is derived from the bond's carrying value multiplied by the market interest rate, while cash payments are based on the principal and stated interest rate. The difference between these amounts represents the amortization of the discount or premium. This method aligns with GAAP, ensuring accurate financial reporting and reflecting the true cost of borrowing over time.

How do you calculate the interest expense using the effective interest method?

To calculate the interest expense using the effective interest method, you multiply the bond's carrying value by the market interest rate. If the bond pays interest semiannually, you divide the annual market interest rate by 2. The formula is:

$\mathrm{Interest} \mathrm{Expense}=\mathrm{Carrying} \mathrm{Value} \times \mathrm{Market} \mathrm{Interest} \mathrm{Rate}$

This interest expense is then used in the journal entries to debit interest expense and credit cash or interest payable.

What is the difference between the effective interest method and the straight-line method for bond amortization?

The effective interest method and the straight-line method are two approaches to amortizing bond premiums or discounts. The effective interest method calculates interest expense based on the bond's carrying value and market interest rate, resulting in varying interest expenses and amortization amounts each period. In contrast, the straight-line method spreads the total premium or discount evenly over the bond's life, resulting in constant interest expense and amortization amounts each period. The effective interest method is preferred under GAAP as it more accurately reflects the true cost of borrowing.

How do you create an amortization table using the effective interest method?

To create an amortization table using the effective interest method, follow these steps:

1. Calculate the initial carrying value of the bond.
2. Determine the cash interest payment using the principal and stated interest rate.
3. For each period, calculate the interest expense by multiplying the carrying value by the market interest rate.
4. Compute the amortization of the discount or premium as the difference between the interest expense and the cash interest payment.
5. Adjust the carrying value by adding the amortization of the discount or subtracting the amortization of the premium.

Repeat these steps for each period until the bond matures.

Why is the effective interest method preferred under GAAP?

The effective interest method is preferred under GAAP because it provides a more accurate representation of the true cost of borrowing over the life of the bond. This method aligns the interest expense with the bond's carrying value and market interest rate, resulting in a more precise reflection of the interest expense and amortization of the premium or discount. By doing so, it ensures that financial statements more accurately depict the financial position and performance of the issuing entity, enhancing the reliability and comparability of financial reporting.