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Effective interest amortization is an accounting principle that attempts to allocate the value of bonds which are sold at either a premium or a discount. Bonds sell for a price other than their face value when the interest rates attached to them are different than the prevailing market interest rates. This excess cash must be allocated in corporation accounting, and effective interest amortization is the preferred method for achieving this. It is calculated by taking the current book value of the bonds and multiplying it by the market interest rate of that particular time period.
Bonds are essentially loans which are given by consumers to corporations, who use the acquired funds for some sort of business financing. In return, investors are promised the return of the bond's face value at the end of the bond term as well as semiannual interest payments. There are times when bonds are sold for more than their face value, which is called a premium, or for less than their face value, which is known as a discount. When either of those two events occurs, effective interest amortization is used to bring the bond's value back to its face value on the accounting ledgers of the corporations involved.
The key factor for bonds being sold for either a premium or a discount are interest rates. If a corporation is offering interest rates higher than prevailing market rates, investors will be willing to pay higher than face value for the bonds, even knowing that they will only receive the face value at the end of the bond term. By contrast, corporations paying lower interest rates will have to settle for lower than face value from investors. In either case, effective interest amortization comes into play.
To calculate effective interest amortization, the market interest rate at the time of the accounting period must be multiplied by the current book value of the bond. Doing this yields the amortization of the premium or discount for that particular period. This amount is then subtracted each time from the total discount or premium, until that number is eventually reduced to zero.
It is important to note that effective interest amortization is not the only method used to account for bonds not sold at face value. The straight-line method simply divides the amount of the excess by the total accounting periods in the life of the bond, and then amortizes that same amount each period. In general, the effective interest method is preferable to this because it takes into account the true value of the bonds for the entire time the method is used.