What is Effective interest method?
In short
The effective interest method amortizes a bond discount or premium so that interest expense each period equals the bond's carrying amount multiplied by the market rate at issuance.
Key takeaways
- Cash interest is face value × stated rate; the difference from interest expense is the amortization.
- With a discount, interest expense rises each period as the carrying amount increases toward face value.
- Straight-line amortization is allowed only if the result isn't materially different.
Example
Bonds issued for $920,162 with a 6% coupon on $1,000,000 and an 8% market rate: year 1 interest expense is $73,613, cash is $60,000 and discount amortization is $13,613.
Where it's tested
FAR: Long-Term Debt (Bonds & Notes) — study notes, a five-minute revision sheet and practice questions.
Practise: 3 questions
Question 1 of 3 · 0 answered
Bonds with a face amount of $500,000 and an 8% annual coupon are issued for $470,000 when the market rate is 9%. Using the effective interest method, what is interest expense for the first year?