How are bond discounts or premiums amortized over the life of the bond?

• A. Using the straight-line method, with equal amortization each period.
• B. Amortized using the straight-line method conditional on market rates.
• C. Using the effective interest method; the interest expense differs from cash interest due to the amortization.
• D. They are expensed immediately.

Answer: (C)

Bond discounts and premiums are amortized using the effective interest method. Each period’s interest expense is based on the market rate at issuance multiplied by the bond’s carrying amount, while the cash interest payment is fixed by the coupon rate and face value. The difference between these two amounts is the amortization for that period. If the bond was issued at a discount, interest expense exceeds cash interest, so the carrying amount increases by the amortization. If issued at a premium, interest expense is less than cash interest, so the carrying amount decreases. Over time, the carrying amount moves toward the face value and ends at maturity. For example, with a bond at a discount, initial cash interest might be lower than interest expense, causing the carrying amount to rise each period; with a premium, the opposite happens. This method reflects the changing cost of borrowing as the balance changes, unlike a straight-line approach which would spread the same amount of amortization each period regardless of market rate.