What is the effective interest rate?

Financial assets meeting the criteria of amortized cost be it to bond or mutual fund has a cash flow stream represented by the coupon rate. The coupon rate is stated at the rate at which the bond pays periodic interest/coupons.

Nonetheless, over the term of the bond, the interest rate prevalent in the market generally differ from interest stated in the coupon. If the market interest rate is higher than the stated interest rate, the bond market price is lower than its maturity value.

This is due to the fact that bond is offering interest rate lower than what is prevalent in the market.

Likewise, if market interest is lower than the coupon rate on the bond, the bond sells at a premium i.e. at a higher price than the maturity value of the bond. 

There can also be rare cases where the market price of the bond and its face value are same that means the coupon rate stated on face value equals the market interest rate.

The treatment of interest as per accounting standard requires that any discount or premium arising on the acquisition of a financial asset carried at amortized cost should be amortized using the effective interest rate method.

Under the effective interest method, the interest income recognized is calculated by applying the market interest rate to the carrying amount of the bond and the difference between the interest income so recognized and the interest income paid is used to write-off the discount or premium such that the discount or premium is zero at the end of the bond term.

Let’s use an example to illustrate the effective interest rate method

On 1 January 2019, Larsson Pvt Ltd. invested in 20,000 Company A bonds whose face value is $100, coupon rate is 6% payable annually and time to maturity is 10 years.

The market rate interest for Larsson Pvt Ltd was 6.5% and Larsson Pvt ltd would pay $1,928,112 for these bonds (calculated by discounting the bonds cash flows stream using the market interest rate

Larsson Pvt Ltd shall record the acquisition of the bonds as follows:

Investments held at amortized cost- Company A bonds$2000,000  
        Cash  $1,928,112
        Discount on Company A bonds  $71,888

Larsson Pvt Ltd shall report the bonds purchased at $1,928,112 on its balance sheet (face value minus discount). The Discount on Company A bonds is a contra-account to the Company A bonds asset account.

The first interest payment is due on 31 December 2019, which shall equal $120,000 (=$2,000,000*6%). However, Larsson Pvt Ltd. can’t record $120,000 as interest income because according to the effective interest method.

 it also needs to account for the initial discount on the bonds. It shall record the receipt of the first interest payment as follows:

Cash ($2,000,000*6%) $ 120,000  
Discount on Company A bonds $ 5327  
        Income from Interest ( 1,928,112*6.5%)   $ 125,327

After the first payment, the value of Company A bonds in books of Larsson Pvt Ltd. shall be as follows:

Face value of Company A bonds $2,000,000
Less: Discount on Company A bonds ($71,888-$5,327) – $66,561
Amortized cost of Company A bonds at 31 December 2015 $1,933,439

The journal entry for the second interest payment i.e. on 31 December 2020 would be as follows:

Cash ($2,000,000*6%) $ 120,000  
Discount on Company A bonds $ 5674  
        Income from Interest ( 1,993,439*6.5%)   $ 125,674

Amortized cost on 31 December 2020 would be $1,939,112. This would continue until after the last interest payment, the amortized cost of bonds will be equal to the maturity value i.e. $2,000,000.

The following amortization table summarize the application of the effective interest rate method over the term of the bond.

Date Interest
Received
Interest
Income
Discount
Amortized
Amortized
Cost
01-Jan-19 1,928,112
31-Dec-19 120,000 125,327 5,327 1,933,439
31-Dec-20 120,000 125,674 5,674 1,939,112
31-Dec-21 120,000 126,042 6,042 1,945,155
31-Dec-22 120,000 126,435 6,435 1,951,590
31-Dec-23 120,000 126,853 6,853 1,958,443
31-Dec-24 120,000 127,299 7,299 1,965,742
31-Dec-25 120,000 127,773 7,773 1,973,515
31-Dec-26 120,000 128,278 8,278 1,981,794
31-Dec-27 120,000 128,817 8,817 1,990,610
31-Dec-28 120,000 129,390 9,390 2,000,000

This is how discount is amortized using effective interest rate method.