The Effective Interests Rate Method
The effective interest rate method is the alternative approach for gradual write off of discounted rate. Through the effective interest rate method, the interest expense amount in a particular period of accounting corresponds with the book value of a bond at the start of the accounting period (Roberts, 123). Thus, the increase in bond value consequently increases the amount of interest expense. For instance, “by selling a discounted bond, the bond’s discount amount must be amortized to interest expense over the life of the bond.” Through the use of the effective interest rate approach, the amount of debt in the discount on payable bonds is shifted to the interest account. Thus, amortization causes the expense of interest in every period to be higher than the interest amount paid in each year of the life of the bond.
The effective interest method is utilized in the evaluation of interest generated by bonds as it considers the effect of bond purchase instead of accounting only for per value. The major advantage of using this approach is that it presents a more precise figure of the exact earned interest on an investment or a financial instrument, or on actually paid loan interest. Analysts and investors also use it in the examination of discounts or premiums related to government bonds; however, similar concepts can also be applied in the trade of corporate bonds.