What is the Effective Interest Method?

What is the Effective Interest Method?

The Effective Interest Method is a technique used for amortizing bonds to show the actual interest rate in effect during any period in the life of a bond before maturity. It is based on the bond’s book value at the beginning of any given accounting period.

The effective interest method calculation can be an important tool when an investor purchases a bond at either a premium or a discount to its face value (also known as par value).

Bonds are typically sold at a premium to their face value when the bond’s stated interest rate is greater than prevailing market rates. Investors are willing to pay a premium for the bond in order to secure higher interest income.

Conversely, bonds typically sell at a discount to their face value when the bond’s stated interest rate is less than prevailing market rates. The bond price must represent a bargain to compensate investors for the lower amount of interest that will be earned by holding the bond.

Formula for Calculating the Effective Interest Rate

The formula used to calculate the effective interest rate is as follows:

Effective Interest Rate – Formula

Where:

  • i = The bond’s coupon rate
  • n = The number of coupon payments per year (i.e., if coupon payments are received monthly, then n would be 12)

Why Use the Effective Interest Rate Method

The effective interest method of amortizing a bond is considered superior to the straight-line amortization method simply because it is more accurate, from period to period, than the straight-line method, under which the same amount is amortized during every period.

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However, the effective interest method requires more work because it needs to be recalculated for every individual interest-earning period. Therefore, it is commonly only used when a bond is purchased at a significant premium or discount or when the bond’s book value increases or decreases significantly during the life of the bond.

For a bond purchased at face value, and where the book value of the bond remains relatively stable throughout its life to maturity, the straight-line amortization method works fine and is less difficult to calculate. In any event, when the bond reaches maturity, both the straight-line amortization and the effective interest rate method of calculating amortization will be equal.

Advantages of  Effective Interest Rate

  • No sudden charge or income to profit and loss account. Discounts and premiums are spread over the life of the bond.
  • Better accounting practices ,like the matching concept, is used in this method.
  • Future impact on profit and loss account is known well in advance, which helps in making a more accurate budget of interest expenditure.

Disadvantages of Effective Interest Rate

  • A method is more complex than the straight-line method of amortization.
  • Not useful for depreciation accounting.

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 concept, like the matching concept, is clearly followed in this method.

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