What is the Effective Interest Method?

When the market rate is more than the coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more, bonds debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more are sold at a discount as a buyer is willing to pay a lesser price than the market price for the bond. When the market rate is lower than the coupon rate, bonds debentures are sold at a premium. In an ideal situation, the coupon rate exactly matches market-rate means the bond is issued at par value.

Effective Interest Method Formula

The formula for calculation of Effective interest method  is as follows,

Effective Interest Rate (r) = (1+i/n)n – 1

Where,

i= rate of interest (coupon rate), n= number of periods per year. If interest is paid semiannually, then the number of years should be divided by 2.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Effective Interest Method (wallstreetmojo.com)

Examples of Effective Interest Method

Below are the examples for calculation of effective interest method –

Example #1 – Bond/ Debenture Issued at Discount

A financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more issued at a discount means a buyer has paid lesser value than the par value of the financial instrument. In such a scenario the difference between the amount paid and the book value of the bond is a discount and is amortized over the life of the bond. Every financial instrument carries a rate of interest, which is called a coupon rate paid annually, semi-annually to the bondholder.

The difference between coupon/interest paid and discount amortized is an accretion to bond value. At maturity, carrying a value of a bond will reach the par value of the bond and is paid to the bondholder. Suppose a 5-year $ 100,000 bond is issued with a 9% semiannual coupon in a 10% market $ 96,149 in Jan’17 with interest payout in June and January.

Solution

Calculation of Interest Payment

  • =100000*4.5%=4500

Calculation of Interest Expense 

The difference will be as follows –

Accounting Entries for Bonds Issued at a Discount

In the Journal of……(For the period ended on 31st December 2018)

Similar entries will be passed every year. At maturity, Bond, A/c will be debited, and bank A/c will be credited with $ 100,000.

Example #2 – Bond/Debenture Issued at Premium

A financial instrument issued at a premium means a buyer has paid more value than the par value of the financial instruments. In such a scenario, the difference between the amount paid and the book value of a bond is premium and is amortized over the life of the bond. Every financial instrument carries a rate of interest, which is called a coupon rate paid annually, semiannually to the bondholder.

The difference between coupon/interest paid and premium amortized is amortization to carrying the value of a bond. At maturity, the carrying amountCarrying AmountThe carrying amount or book value of asset is the cost of tangible, intangible assets or liability recorded in the financial statements, net of accumulated depreciation or any impairments or repayments. Accordingly, the carrying amount may differ from the market value of assets.read more of the bond will reach the par value of the bond and is paid to the bondholder. Suppose a 5-year $ 100,000 bond is issued with a 6% semiannual coupon in an 8% market $ 108,530 in Jan’17 with interest payout in June and January.

Accounting Entries for Bonds Issued at a Premium

Example #3 – Bond/Debenture Issued at Par

A financial instrument issued at par means the buyer has paid the exact value for the financial instruments. In such a scenario, the coupon rate is equal to the market rate. Since carrying the value of the bond is exactly equal to the par value of the bond, the effective interest method is not applicable. Normal journal entries will be passed on the issuance of bonds, accrual, and payment of interest, payment of principal amount at maturity.

Practical Applications of Effective Interest Method

  • Bonds/debentures issued at discount and premium.Calculating the present value of security deposits under IFRS.Calculating the present value of minimum lease payments under leasing arrangements.

Advantages

  • No sudden charge or income to profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more. Discounts and premiums are spread over the life of the bond.Better accounting practicesAccounting PracticesAccounting practice is a set of procedures and controls used by an entity’s accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor’s reliance while auditing the financial statements.read more, like the matching concept, is used in this method.Future impact on profit and loss accounts is known well in advance, which helps in making a more accurate budget of interest expenditure.

Disadvantages

  • A method is more complex than the straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more of amortization.Not useful for depreciation accountingDepreciation AccountingDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
  • read more.

Conclusion

Based on the above discussion, we can conclude that the effective interest method is a more accurate way of calculating interest expenditure than other methods. Although the effective interest method has some limitations, the accounting conceptThe Accounting ConceptAccounting concepts are the principles, assumptions, and conditions that govern accounting’s foundation. They ensure that the accounting is done in a way that the financial statements present a true and fair view.read more, like the matching concept, is clearly followed in this method.

This has been a guide to Effective Interest Method. Here we discuss the calculation of effective interest methods along with its examples, advantages, disadvantages, and practical applications. You can learn more from the following articles –

  • Effective Interest Rate CalculationBond FormulaCalculate Carrying ValueCalculate Dollar Duration