Effective Interest Method

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DEFINITION of 'Effective Interest Method'

The practice of accounting for the discount at which a bond is sold as an interest expense to be amortized over the life of the bond. Using this method, additional interest expense is calculated using the prevailing market interest rate at the time of the bond issue. The market rate is multiplied by the book value of the bond to find the amount of the discount to be amortized as interest expense each period.

BREAKING DOWN 'Effective Interest Method'

The effective interest method is regarded as one of the preferred methods for amortizing a bond discount. In theory, investors demand a discount on bonds because the market interest rate at the time of issue exceeds the coupon payments on the bond. Thus, by amortizing the discount at the market interest rate, a company's accounting statements more closely reflect the economic reality of the bond issue and the firm's true cost of debt.



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RELATED FAQS
  1. What is the effective interest method of amortization?

    The effective interest method is an accounting practice used for discounting a bond. This method is used for bonds sold at ... Read Full Answer >>
  2. How does the effective interest method treat the interest on a bond?

    The effective interest method is used when evaluating the interest generated by a bond because it considers the impact of ... Read Full Answer >>
  3. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  4. How do dividend distributions affect additional paid in capital?

    Whether a dividend distribution has any effect on additional paid-in capital depends solely on what type of dividend is issued: ... Read Full Answer >>
  5. Why can additional paid in capital never have a negative balance?

    The additional paid-in capital figure on a company's balance sheet can never be negative because companies do not pay investors ... Read Full Answer >>
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