Accounting Dictionary
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Effective Interest Method
The effective interest method is a technique for calculating the actual interest rate in a period based on the amount of a financial instrument's book value at the beginning of the accounting period. Thus, if the book value of the financial instrument decreases, so too will the amount of related interest; if the book value increases, so too will the amount of related interest. This method is used to properly account for bond premiums and discounts.
If an entity buys or sells a financial instrument for an amount other than its face amount, this means that the interest rate it is actually earning or paying on the investment is different from the stated interest paid on the financial instrument. For example, if a company buys a financial instrument for $95,000 that has a face amount of $100,000 and which pays interest of $5,000, then the actual interest it is earning on the investment is $5,000 / $95,000, or 5.26%.
The effective interest rate, which is used in the calculation, exactly discounts estimated future cash payments or receipts over the expected life of the instrument under the effective interest method. In essence, interest income or expense in a period is the carrying amount of a financial instrument multiplied by the effective interest rate.
For example, Svelte Equipment Company, which makes fine chrome-plated weight lifting equipment, acquires a debt security having a stated principal amount of $100,000, which the issuer will repay in three years. The debt has a coupon interest rate of five percent, which it pays at the end of each year. Svelte acquires the debt for $90,000, which is a discount of $10,000 to the principal amount of $100,000. Svelte classifies the investment as held-to-maturity, and records this entry:
| Debit | Credit | |
| Held-to-maturity investments | 90,000 | |
| Cash | 90,000 |
Based on a cash outflow of $90,000 to acquire the investment, three interest payments of $5,000 each, and a principal payment of $100,000 upon maturity, Svelte calculates an effective interest rate of 8.95 percent. Using this interest rate, Svelte calculates the following amortization table with the effective interest method:
Year |
(A) Beginning Amortized Cost |
(B) Interest and Principal Payments |
(C) Interest Income [A x 8.95%] |
(D) Debt Discount Amortization [C – B] |
Ending Amortized Cost [A + D] |
| 1 | 90,000 | 5,000 | 8,055 | 3,055 | 93,055 |
| 2 | 93,055 | 5,000 | 8,328 | 3,328 | 96,383 |
| 3 | 96,383 | 105,000 | 8,617 | 3,617 | 100,000 |
Using the table, Svelte makes the following entries at the end of each of the next three years:
Year 1:
| Debit | Credit | |
| Cash | 5,000 | |
| Held-to-maturity investment | 3,055 | |
| Interest income | 8,055 |
Year 2:
| Debit | Credit | |
| Cash | 5,000 | |
| Held-to-maturity investment | 3,328 | |
| Interest income | 8,328 |
Year 3:
| Debit | Credit |
|
| Cash | 105,000 | |
| Held-to-maturity investment | 96,383 | |
| Interest income | 8,617 |
The effective interest method is preferable to the straight-line method of charging off premiums and discounts on financial instruments, because it is considerably more accurate. However, it is also more difficult to compute than the straight-line method.
