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.

INVESTOPEDIA EXPLAINS '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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