A company issues a 10-year, $1,000,000 bond on January 1, Year 1, with a stated interest rate of 6% payable annually on December 31. The market interest rate on the issuance date was 5%. The bond was issued for $1,077,217. Using the effective interest method, what is the interest expense recognized for the year ended December 31, Year 1?
- A$60,000
- B$42,278
- C$53,861
- D$50,000
Show answer & explanationAnswer & explanation
Correct answer: C. $53,861
Under the effective interest method, interest expense is calculated by multiplying the carrying amount of the bond at the beginning of the period by the market interest rate at the time of issuance. Carrying amount at Jan 1, Year 1 = $1,077,217 (issue price). Market interest rate = 5%. Interest expense = $1,077,217 * 5% = $53,860.85, which rounds to $53,861.
Why the other options are wrong
- A. Incorrect. This is the cash interest paid, which is (Face Value * Stated Rate).
- B. Incorrect. This is an arbitrary value.
- D. Incorrect. This is face value * market rate, but not carrying amount * market rate.
Effective Interest Method (Bonds)
The effective interest method calculates bond interest expense by multiplying the bond's carrying amount (book value) at the beginning of the period by the effective (market) interest rate at the time of issuance. This method systematically amortizes any bond premium or discount over the life of the bond.
- Calculates interest expense based on carrying amount and market rate.
- Amortizes bond premiums/discounts.
- Interest expense changes each period as carrying amount changes.
- Cash interest paid is based on face value and stated rate.
- Required under GAAP unless results are immaterially different from straight-line.
Memory trick: Effective Interest: Carrying Value times Market Rate – that's your true expense.