01 Mar Effective Interest Rate Financial Accounting
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The primary advantage of using the effective interest rate is simply that it is a more accurate figure of actual interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage. Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate. The coupon rate is the amount of interest generated by the bond each year, expressed as a percentage of the bond’s par value.
The initial journal entry to record the issuance of the bonds, and the final journal entry to record repayment at maturity would be identical to those demonstrated for the straight-line method. The amount of cash to be paid, the interest expense, and the premium or discount amortization with each periodic payment are calculated based on an amortization table or schedule. If a straight line method were used to allocate interest expense, the bond interest expense would be equal for every single payment. Well, the semi-annual interest expense dollar amount will remain equal, but the percentage in relation to the bond will change. For instance, as the bond payments are made, interest is being expensed and the bond premium or discount is reducing or increasing the loan balance. If the interest expense dollar amount stayed the same each payment, the percentage of interest would change.
Summary of the Effect of Market Interest Rates on a Bond’s Issue Price
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. 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 prior to maturity. For loans such as a home mortgage, the effective interest rate is also known as the annual percentage rate. The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan.
Through the life of the bond, the interest rate index and total coupon amount resets as shown in the following table. Finance Co has elected a policy of using the rate in effect at inception of a financial asset for purposes of determining the https://kelleysbookkeeping.com/ asset’s effective interest rate. 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.
Effective Interest Amortization of Bond Premium or Discount
In the real world, amortization accounts for the difference between what you collect and what you pay back. The Effective Interest Method corrects this problem by allocating interest expense to the bond payable each payment. That way the bond interest expense is always equal to the market interest rate of return. Fees relating to revolving credit facilities and other loan commitments are not part of the effective interest rate. As noted during one of the discussions on our Forum, a fee paid by the borrower is not specific to the amount borrowed.
IAS 32 or IFRS 9 do not deal explicitly with taxes on financial instruments, but this is probably because VAT is a levy imposed by the government, so it’s in the scope of IFRIC 21. This means that it should be expensed in P/L when the obligation arises. In other words, VAT should not be treated as part of the cash flows of a financial instrument, also because VAT payments do not result from the contract between parties.
Effective Interest Method of Amortization FAQs
Unlike the real interest rate, the effective interest rate does not account for inflation. For lenders or investors, the effective interest rate reflects the actual return far better than the nominal rate. Hearst Newspapers participates in various affiliate What Is The Effective Interest Method Of Amortization? marketing programs, which means we may get paid commissions on editorially chosen products purchased through our links to retailer sites. Below we walk through how we calculate each methodology and why we support these four methodologies specifically.