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Definition: Effective Interest Method
For calculating the actual interest rate of a financial instrument during a time period, based on the book value of the instrument at the start of an accounting period, Effective Interest Rate Method is used. In case the book value of the financial instrument decreases, the interest paid off will also decrease. Similarly in case of increasing value of the financial instrument, the interest paid increases. Financial instruments like bonds are sold at a discount (quoted interest rate being lower than market rate) or premium (quoted interest rate being higher than the market rate) – discount/premium is the interest expense that is amortized through the lifetime of the bond.
Instead of using straight line method to allocate interest expense (which would give equal interest amount for each period), effective interest rate method returns are more accurate for periodic intervals. This is more difficult to calculate, since it must be calculated for every period. At the end of amortization period, the amounts charged will be equal in case of both effective interest and straight line methods. Straight line method is used where the premium/discount values are immaterial.
Let us assume, Company X intends to issue a bond with face value of $10,000 having a maturity of 5 years and annual coupon of 8%. At the time of issue if the market interest rate goes up to 10% and the bond gets a price of $9242. (Bond issued at a discount)
First year: The interest calculated for market rate of 10% would be $924.20, however interest paid at quoted rate would be $800. Amortized value=$124.20
In year 2 the carrying amount would be $9366.20 ($9242 plus the amortized bond discount of $124.20). The interest expense is $936.62. Since interest to be paid would be the same i.e. $800 this would lead to a higher amount for bond discount amortized during the period. Company X would now record the following entry:
Therefore we observe that under the effective interest method the amount of bond discount amortized increases over the life of the bond.