Bond Amortization with the Effective Interest Method

Step 1 — Identify the cash flows.
The bond pays $5,000 of cash interest every six months (250,000 × 4% × ½) and returns $250,000 of principal at the end of year 6. With a 6% market yield, the semiannual market rate is 3%.

Step 2 — Compute the issue price.
Discount the 12 semiannual interest payments and the principal repayment at 3% per period:
PV of interest payments = 5,000 × PVA(3%, 12) = 5,000 × 9.9540 = 49,770
PV of principal = 250,000 × PVF(3%, 12) = 250,000 × 0.7014 = 175,350
Issue price ≈ 225,120

The bond sells at a discount of about $24,880 because the stated rate (4%) is below the market rate (6%).

Step 3 — Build the amortization schedule.
Each period:
• Interest expense = beginning carrying value × 3%
• Cash interest paid = 5,000 (constant)
• Discount amortization = interest expense − cash interest
• New carrying value = old carrying value + amortization

Period 1: 225,120 × 3% = 6,754 expense. Amortization = 1,754. New CV = 226,874.
Period 2: 226,874 × 3% = 6,806 expense. Amortization = 1,806. New CV = 228,680.
Period 3: 228,680 × 3% = 6,860 expense. Amortization = 1,860. New CV = 230,540.

Step 4 — Journal entry for the first interest payment (Jan 1, 2026).
Dr Interest Expense 6,754
Cr Discount on Bonds Payable 1,754
Cr Cash 5,000

Key takeaways:
• The discount is amortized over the life of the bond — by maturity, the carrying value equals the $250,000 face.
• Interest expense GROWS each period because the carrying value grows. (For a premium, expense shrinks.)
• Never use the stated rate to compute interest expense — always use the effective (market) rate at issuance.