How to Find Interest With the Straight-Line Method

By Markets Fool.com

The straight-line method is the simplest way to account for the amortization of a bond on a company's financial statements. This method attributes equal interest expense to every accounting period until the bond matures.

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To calculate the interest for each period, simply divide the total interest to be paid over the life of the bond by the number of periods, be it months, quarters, years or otherwise.

Bonds can be more complicated than other debts
For most term bank debt like mortgages or installment loans, the straight-line method is very simple. The total interest is predefined by the contractual rate and term, and the principal amount is clearly defined and fully funded. The process to calculate annual interest expense in these cases is then just simple division.

Bonds, on the other hand, can be more complex. Bonds can be issued at a premium, a discount, or tied to market rates. These added variables can create more complexity when calculating the interest with the straight-line method, however, the overall concept remains consistent and logical.

An example of finding interest expense with the straight-line method
For example, say that a company wants to issue a 10-year bond for $10 million at a 5% annual rate. We'll assume this the bond pays annually for simplicity.

Instead of working with a single bank where terms can be negotiated directly, the company must cede to market conditions to get its funding. In this case, let's assume that the market is skittish of the offering and requires a discount. The company will receive just $9.75 million in funding, but will still have to pay back the full $10 million principal value plus 5% interest.

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In this case, the straight-line method would include both the explicitly defined interest in the bond as well as the implicitly defined interest from the discount. That means the accountant would calculate the total interest based on a 5% rate applied to $10 million in principal for 10 years that works out to $5 million plus $250,000 in implied interest from the difference between the $10 million face value and the discounted $9.75 million funded.

That totals $5.25 million in total interest expense, which should next be divided by the 10-year duration of the bond. This results in $525,000 in level interest expense each year for the life of the bond.

The accountants will record this on the financial statements each year with a debit to interest expense of $525,000, balanced by a credit to cash of $500,000 and a credit to "discount on bonds payable" for $25,000.

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