Effective interest method

The effective interest method is used in the calculation of the amortised cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period. But many assets and liabilities valued at amortised cost are valued at cost, because they are received or paid within a short period (i.e. discounted value equals cost). Effective interest method

The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (e.g., prepayment, call and similar options) but shall not consider future credit losses. Effective interest method

The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

However, in those rare cases when it is not possible to estimate reliably the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments). Effective interest method

Under the effective interest rate method, the amount of interest expense in a given accounting period correlates with the book value of a bond at the beginning of the accounting period. Consequently, as a bond’s book value increases, the amount of interest expense increases. Effective interest method

When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. Therefore, the amortization causes interest expense in each period to be greater than the amount of interest paid during each year of the bond’s life.

For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market. The bond is sold at a discount for $95,000 on January 1, 2017. Therefore, the bond discount of $5,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond.

The effective interest method of amortization causes the bond’s book value to increase from $95,000 January 1, 2017, to $100,000 prior to the bond’s maturity. The issuer must make interest payments of $3,000 every six months the bond is outstanding. The cash account is then credited $3,000 on June 30 and December 31.

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EXAMPLE

The effective interest rate method for a 5-year 9% $100,000 bond issued in a 10% market for $96,149:

1. The bond discount of $3,851 must be amortised to Interest Expense over the life of the bond. The amortisation will cause the bond’s book value to increase from $96,149 on January 1, 2018 to $100,000 just prior to the bond maturing on December 31, 2022.
2. The corporation must make an interest payment of $4,500 ($100,000 x 9% x 6/12) on each June 30 and December 31 that the bonds are outstanding. The Cash account will be credited for $4,500 on each of these dates.
3. The effective interest rate is the market interest rate on the date that the bonds were issued. The market interest rate on January 1, 2018 obtained from market data of comparable bonds was 10%.
4. The effective interest rate is multiplied times the bond’s book value at the start of the accounting period to arrive at each period’s interest expense.

The following table illustrates the effective interest rate method of amortising the $3,851 discount on bonds payable:

	Payment date	Interest payment	Interest expense in profit or loss at 10% (annual rate)	Difference Discount amortisation	Discount in bond payable	Nominal value bond payable	Net carrying amount reported in financial position
	01/01/2018				3,851	100,000	96,149
	30/06/2018	4,500	4,807 1	307 2	3,544 3	100,000	96,456 4
	01/01/2019	4,500	4,822	322	3,222	100,000	96,778
	30/06/2019	4,500	4,839	339	2,883	100,000	97,117
	01/01/2020	4,500	4,856	356	2,527	100,000	97,473
	30/06/2020	4,500	4,874	374	2,153	100,000	97,847
	01/01/2021	4,500	4,892	392	1,761	100,000	98,239
	30/06/2021	4,500	4,912	412	1,349	100,000	98,651
	01/01/2022	4,500	4,933	433	916	100,000	99,084
	30/06/2022	4,500	4,954	454	462	100,000	99,538
	31/12/2022	4,500	4,962 5	462	–	100,000	100,000
		45,000	48,851	3,851

Journal entry 01/01/2018

	Financial position		Profit or loss
Cash	96,149
Discount on bond payable	3,851
Bond payable		100,000

Journal entry 30/06/2018

	Financial position		Profit or loss
Cash		4,500
Discount on bond payable		307
Interest expense			4,807

An so on …….

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Effective interest method