The effective interest method is used to account for bonds sold at a discount, with the difference between the sales price and face value representing an additional cost of borrowing that must be spread out over the life of the bond. This method calculates the interest payment that would be due on the bond if it were to account for the prevailing market rate from the date of issuance and attributes the difference to an additional interest cost.
The effective interest method is a way of accounting for bonds that are sold at a discount. Such sales create a mismatch between the amount the issuing company receives upfront and the amount it is required to pay. The disparity represents a cost, which the company will need to spread out over the life of the bond for accounting purposes, a process known as amortization. The effective interest method is a percentage-based method of calculating this division.
Under normal circumstances, a bond issuer’s calculations are reasonably simple. The cost of the bond is simply the interest rate. If, for example, you issue a $100,000 US dollar (USD) bond to be repaid after one year at an interest rate of 5%, your total cost will be $5,000 USD, shown as an expense in the accounts of the company. If the bond has a life of several years, the total cost can simply be divided over the years for accounting purposes. If the terms of the bond call for an annual interest payment, there’s not even a need for a split: Expenses can simply be noted each year as they occur.
This simple situation can become more complicated if, for some reason, the interest rate on a bond is below the average available in the market for similar bonds. In this case, the company will need to sell the bond below face value to attract any buyers. In such a situation, the interest payments are still based on the face value of the bond and are listed as expenses in the normal way. The problem with this situation is that the difference between the sales price and the face value of the bond represents a loss to the company, and therefore an additional cost of borrowing through the bond that must be accounted for. Since the benefit associated with this cost, ie borrowing, lasts for several years, the company will generally want to spread the additional cost over the life of the bond.
The most common way to deal with this situation is the effective interest method. Each year, the company calculates the interest payment that would be due on the bond if it were to account for the prevailing market rate from the date of issuance. The company then calculates the difference between this amount and the actual amount you pay in interest, which is of course based on the actual face value of the bond. This difference is attributed to an additional interest cost. Over the life of the bond, these additional interest costs will add up to equal the total additional expense the company acquired by issuing at a discount.
The effective interest method should not be confused with the methods of calculating an interest rate on a loan or credit agreement. In this context, the references to effective rates can cover two calculation elements. One is to allow a fair comparison between different loans that earn interest at different intervals; This is done by calculating the total interest accrued over a year. Another meaning is for an annual comparison of the total amount to be paid during a year, taking into account both interest payments and fees. The requirements and terminology for the effective calculation of interest vary by jurisdiction.
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