## Monday, October 10, 2011

### Total Interest Cost Components

CFA Level 1 - Liabilities

Total interest expense, which is reported on the income statement, includes the total coupon payment plus a portion of the underappreciated discount or premium for the specified accounting period.

U.S. GAAP allows companies to amortize premiums or discounts by utilizing a straight-line amortization or the effective interest rate method.

Straight-line Depreciation

Formula 9.2

Depreciation amount = premium or discount at issue
payment periods

Example
Company ABC issues a \$1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation. The company issues at \$1,038,609 and face value is \$1m.

Interest expense = coupon payments - unamortized portion of bond premium for the period

The carry value = total market value at time of issue - cumulative amortized premium or discount

Unamortized portion of bond premium for every period (six months in this example) = \$38,609 / (10 payment periods) = \$3,860.9

Result
Under this method the issuing company will recognize an equal amount of unamortized depreciation for every period.

Effective Interest Rate MethodEffective interest rate method results in an interest expense that is a constant percentage of the carrying value of the bonds; thus interest expense varies from period to period. In contrast, the straight-line method results in a constant interest expense from period to period.

Formula 9.3

Interest expense = current interest rate at time of issue * carry value

The carry value = total market value at time of issue - cumulative amortized premium or discount

Formula 9.4

Amortized premium (discount) = coupon payment - interest expense

Example
Company ABC issues a \$1m bond that will pay a 11% semiannual (coupon) for five years, and similar bonds are paying 10%. Bond premiums are amortized using the effective interest rate depreciation method. The company issues at \$1,038,609 and face value is \$1m.

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