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The effective interest method is a way of accounting for bonds that are sold at a discount. Such sales create a disparity between the amount the issuing company receives up front and the amount it must repay. The disparity represents a cost, which the company will need to split across the lifespan of the bond for accounting purposes, a process known as amortization. The effective interest method is a percentage-based method of calculating this split.
In normal circumstances, a bond issuer's calculations are reasonably simple. The cost of the bond is simply the interest rate. If, for example, it issues a $100,000 US Dollar (USD) bond to be repaid after one year at a 5% interest rate, its total cost will be $5,000 USD, which is listed as an expense on the company's accounts. If the bond has a lifespan of multiple years, the total cost can simply be split over the years for accounting purposes. If the bond terms call for an annual interest payment, there isn't even a need for a split: The expenses can simply be chalked up each year as they occur.
This simple situation can become more complicated if, for whatever reason, the interest rate on a bond is below the average available across the market for similar bonds. In this case the company will need to sell the bond at below its face value to attract any buyers. In such a situation, the interest payments are still based on the face value of the bond and listed as expenses in the normal manner. The problem with this situation is that the difference between the sale price and the face value of the bond represents a loss to the company, and thus effectively an additional cost of borrowing through the bond that must be accounted for. As the benefit associated with this cost, namely the borrowing, lasts for several years, the company will usually want to split the additional cost across the lifespan of the bond.
The most common way of dealing with this situation is the effective interest method. Each year, the company calculates the interest payment that would be due on the bond if it carried the prevailing market rate from the date it was issued. The company then calculates the difference between this amount and the actual amount it pays in interest, which is of course based on the actual face value of the bond. This difference is then chalked up as an additional interest cost. Over the lifespan of the bond, these additional interest costs will add up to equal the total extra expense the company acquired by issuing at a discount.
The effective interest method should not be confused with methods of calculating an interest rate on a loan or credit agreement. In this context, references to effective rates can cover two elements of calculation. One is to allow a fair comparison between different loans that compound interest at different intervals; this is done by calculating the total interest accrued during one year. Another meaning is for an annual comparison of the total amount payable over a year, taking into account both the interest payments and any fees. Requirements and terminology for effective interest calculations vary depending on the jurisdiction.