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.

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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
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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 …….


Effective interest rate method

Effective interest method

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