Question

What is the effective interest method for accounting for debt?

Answer 1

The effective interest method is an accounting standard used to amortize, or discount a bond. This method is used for bonds sold at a discount, where the amount of the bond discount is amortized to interest expense over the bond's life.

Under the effective interest method, the effective interest rate, which is a key component of the calculation, discounts the expected future cash inflows and outflows expected over the life of a financial instrument. In short, the interest income or expense recognized in a reporting period is the effective interest rate multiplied by the carrying amount of a financial instrument.

FORMULA OF EFFECTIVE INTEREST=

r = (1 + i/n)^n-1

Where:

r = The effective interest rate

i = The stated interest rate

n = The number of compounding periods per year

For example, a loan document contains a stated interest rate of 10% and mandates quarterly compounding. By entering this information into the effective interest rate formula, we arrive at the following effective interest rate:

Accounting standard used to amortize, or discount a bond