Start with the intuition. A bond is a package of promised cash flows, periodic coupons plus face value at maturity. The coupon rate is written into the contract and never changes. The market yield is the return lenders demand today for this borrower's risk. So the price is just a present value:
Issue price = PV of all coupons + PV of face value, discounted at the market yield
How does the effective interest method work?
Three cases follow from that:
- Coupon = yield. The promised cash flows are what the market demands, so the bond issues at par.
- Coupon < yield. The coupons are stingy, so lenders pay less than face to make up the return. That's a discount.
- Coupon > yield. The coupons are generous, so lenders pay more than face. That's a premium.
One rule runs everything after issuance:
Interest expense = opening carrying amount × effective interest rate
where the effective rate is the market yield at issuance, locked for the instrument's life. The market will move afterward, and your books won't care, because you borrowed at that price. The cash coupon is fixed by contract. The gap between expense and coupon adjusts the carrying amount, which walks toward face value and gets there on the maturity date. That walk is called the pull to par. US GAAP (ASC 835), IFRS 9 and Ind AS 109 all use this method. It's one of the rare areas where the frameworks fully agree.
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Worked example: a 3-year discount bond
Here's a 3-year discount bond, worked in full. Meridian Finance Ltd (a synthetic Indian NBFC) issues a non-convertible debenture with face ₹100 crore, an annual coupon of 8% and a 3-year term. Investors demand 10%, so the issue price is:
Price = 8/(1.10) + 8/(1.10)² + 108/(1.10)³ = 7.27 + 6.61 + 81.14 = ₹95.03 crore
| Year | Opening carrying amount | Interest expense (10%) | Cash coupon (8%) | Discount amortized | Closing carrying amount |
|---|---|---|---|---|---|
| 1 | 95.03 | 9.50 | 8.00 | 1.50 | 96.53 |
| 2 | 96.53 | 9.65 | 8.00 | 1.65 | 98.18 |
| 3 | 98.18 | 9.82 | 8.00 | 1.82 | 100.00 |
The figures are in ₹ crore. Work to 4 decimals in your spreadsheet and it ties. Now read it like an analyst. Interest expense runs from 9.50 up to 9.82. It's above the 8.00 of interest paid in every single year, and it rises as the carrying amount accretes. Add it up and lifetime expense = 9.50 + 9.65 + 9.82 = 28.97, which is total coupons of 24.00 plus the full discount (100 − 95.03 = 4.97). So the discount is really prepaid interest, recognized over the life, not when paid.
Now the year-1 journal entries. At issuance it's Dr Cash 95.03 · Cr Bonds payable 95.03. That's the net presentation. The gross form you'll see in US classrooms, payable 100 less a contra discount of 4.97, gives the same carrying amount. At year-end it's Dr Interest expense 9.50 · Cr Cash 8.00 · Cr Bonds payable 1.50, and at maturity Dr Bonds payable 100 · Cr Cash 100. A bond retired early doesn't settle so tidily. The cash paid rarely equals the carrying amount on that date, and the difference is an extinguishment gain or loss that goes to profit. You'll work that entry, and the analyst adjustment, on the extinguishment of debt page.
Where does the cash show up? Proceeds come in through CFF and repayment goes out through CFF. Coupons go in CFO under US GAAP and in CFO or CFF under IFRS. Under Ind AS 7 they must go in CFF for non-financial companies. Remember that one, because it comes back in leases. The non-cash amortization is an add-back within CFO.
What changes for a premium bond or issue fees?
Now flip it to a premium. Take the same bond with a 12% coupon and the market still at 10%, and the price is ₹104.97 crore. Expense (10% × carrying amount) now comes in below the coupon, and the difference amortizes the premium down to face:
| Year | Opening | Interest expense (10%) | Coupon (12%) | Premium amortized | Closing |
|---|---|---|---|---|---|
| 1 | 104.97 | 10.50 | 12.00 | (1.50) | 103.47 |
| 2 | 103.47 | 10.35 | 12.00 | (1.65) | 101.82 |
| 3 | 101.82 | 10.18 | 12.00 | (1.82) | 100.00 |
Symmetry is your check. A discount accretes up and a premium amortizes down. Both finish at face.
Then there are issuance fees. Bankers, lawyers and rating agencies all take a cut of the proceeds. Both frameworks deduct issuance costs from the carrying amount and let the effective rate absorb them. US GAAP presents them as a direct deduction per ASU 2015-03, and IFRS 9/Ind AS 109 fold them into the effective rate by definition. Either way, fees push the true borrowing cost above the stated yield. Give Meridian's discount bond ₹2 crore of costs and the net proceeds are 95.03 − 2.00 = ₹93.03 crore. Solve for the rate that discounts (8, 8, 108) to 93.03 and you get ≈ 10.85%. Year-1 expense becomes 93.03 × 10.85% = 10.09, against 9.50 without fees, and the carrying amount runs 95.12, then 97.43, then 100.00. Nothing in the contract changed. Even so, the economic cost of this borrowing is 10.85%. It isn't the 8% coupon, and it isn't the 10% gross yield either. That's the number the cost of debt estimate wants.
Zero-coupon debt and current maturities
Zero-coupon debt is the limiting case. With no coupons at all, everything is accretion, and worked example 1 builds the full schedule. Watch what it does to CFO. You get interest expense with no interest paid.
Current maturities can turn into a covenant trap. Long-term debt due within 12 months is reclassified to current liabilities. US filings call it "current portion of long-term debt", and Schedule III in India calls it "current maturities of long-term debt". Read it against cash and expected CFO. A company with ₹8,000 crore of current maturities and ₹1,500 crore of cash is making a refinancing bet, and refinancing is what vanishes in a credit crunch. That's the IL&FS/DHFL failure mode, and its full anatomy is on the IL&FS crisis page. There's one sharp cross-standard difference here. Say a covenant is breached at year-end, which makes the debt repayable on demand. IAS 1/Ind AS 1 require a waiver to exist at the reporting date for the debt to stay non-current. US GAAP (ASC 470) accepts a waiver obtained after year-end but before the financials are issued. Same facts, different balance sheets.
Where to find it in the filings
You'll find all of this in the debt note. In the US it's the 10-K "Debt" note, with the maturity ladder, fixed vs floating, weighted-average effective rates, and unamortized discounts and issuance costs. Apple's is a clean specimen. It has tens of billions of term notes across many tranches, mostly issued at small discounts, with effective rates disclosed per tranche (pull the latest 10-K from EDGAR). In India it's the Schedule III borrowings note: secured vs unsecured, NCDs vs term loans vs ECBs, security, repayment terms. Reliance Industries' annual report carries one of India's most instructive borrowings notes (illustrative; pull the actual filing). Read it alongside the SEBI LODR credit-rating and debenture-trustee disclosures.