What is the effective interest method?
The effective interest method is used for the amortization of unamortized bond discounts and bond premiums. The effective interest that the issuer will pay is determined in the existing market, not in the bonds contract.
If the coupon rate exceeds the market rate, the bonds will be selling at a premium. If the market rate exceeds the coupon rate, the bonds will be selling at a discount. The issuance price is determined by discounting the payments to the present value by applying the effective interest rate method.
This is required for both United States Generally Accepted Accounting Principles (GAAP), as well as for International Financial Reporting Standards (IFRS). Interest expense under the effective interest method is computed as follows:
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