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CFA Level I · CFA Level I Exam · Topics in Long-Term Liabilities and Equity

A company issues a bond at a premium and uses the effective interest rate method. Compared with the coupon payment, the annual interest expense reported in the income statement is most likely:

Interest expense is lower than the coupon payment, and the difference reduces the carrying amount. A premium bond has a market yield below its coupon rate, so the effective interest charge is smaller than cash paid, and the excess amortizes the premium.

  1. AEqual to the coupon payment in every period
  2. BLower than the coupon payment, with the difference reducing the carrying amountCorrect
  3. CHigher than the coupon payment, with the difference increasing the carrying amount

Explanation

For a premium bond, the market rate is below the coupon rate, so effective interest (market rate × carrying amount) is less than the coupon. The excess cash paid amortizes the premium and lowers the carrying amount toward face value. The third option describes a discount bond.

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