The straight-line method is the simplest way to record the amortization of an obligation in a company’s financial statements. This method assigns equal interest expense to each accounting period until the obligation matures.
To calculate the interest for each period, simply divide the total interest payable over the life of the bond by the number of periods, whether they are months, quarters, years, or whatever. .
Bonds can be more complicated than other debts
For most term bank debts like mortgages or installment loans, the straight-line method is very simple. Total interest is predefined by the contract rate and term, and the principal amount is clearly defined and fully funded. The process of calculating annual interest expense in these cases is then a simple divide.
Bonds, on the other hand, can be more complex. Bonds can be issued at a premium, discount or tied to market rates. These added variables can create more complexity when calculating interest with the linear method, however, the overall concept remains consistent and logical.
An example of calculating interest expense using the straight-line method
For example, suppose a company wants to issue a 10-year bond for $ 10 million at an annual rate of 5%. We’ll assume that the bond pays every year for simplicity.
Instead of working with a single bank where the terms can be negotiated directly, the company must give in to market terms to obtain its financing. In this case, suppose the market is reluctant to the offer and demands a discount. The company will only receive $ 9.75 million in financing, but will still have to repay the full principal value of $ 10 million plus 5% interest.
In this case, the straight-line method would include both the interest explicitly defined on the obligation as well as the interest implicitly defined for the discount. This means that the accountant would calculate the total interest based on a 5% rate applied to $ 10 million in principal for 10 years – this equates to $ 5 million – plus $ 250,000 of implied interest on the loan. difference between the face value of $ 10 million and the discounted $ 9.75. million funded.
This adds up to $ 5.25 million in total interest expense, which should then be divided by the 10-year term of the bond. This translates into a flat interest charge of $ 525,000 each year over the life of the bond.
Accountants will record this on the financial statements each year with an interest expense charge of $ 525,000, balanced by a cash credit of $ 500,000 and a “bond discount” credit of $ 25,000.
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