Two Methods of Amortization of a Discount or Premium Are

question 7

Essay

Two methods of amortization of a discount or premium are used by businesses. These two methods are the effective interest method and the straight-line method.
Required:
a. Explain how premiums and discounts are amortized using the straight-line and effective interest methods.
a. The straight-line method assumes that interest expense will be constant each period. Premium/discount amortization under this method is accomplished by dividing the premium or discount by the number of interest payment periods. The resulting amount is added to/deducted from interest expense in equal amounts each period. Interest expense is the interest paid plus or minus the discount or
b. State which of the two methods is preferred and explain why.
c. Explain why many companies are able to use the method that is not considered GAAP.

---

Definitions:

Net Present Value

A financial metric used to evaluate the profitability of an investment, calculated by discounting all expected future cash flows to their present value using a specific discount rate.

Annual Rate of Return Technique

A method of evaluating investments by calculating the expected annual rate of profit or loss.

Annual Cash Inflows

The total amount of money received by a company or individual within a year from various sources.

Economic Life

Economic life is the estimated period over which an asset is expected to be useful to the owner for the purpose of generating income or other economic benefits.