Question

In the effective interest rate method, what does it produce as a constant dollar amount of interest expense to be reported each interest period?

a. Increasing dollar amount
b. Constant dollar amount
c. Decreasing dollar amount
d. Variable dollar amount

Answer 1

The Effective Interest Rate method produces a constant dollar amount of interest expense each interest period, providing a steady figure that reflects the financial transaction's economic reality.

Step-by-step explanation:

The Effective Interest Rate method of interest calculation produces a constant dollar amount of interest expense to be reported in each interest period. This means that although the outstanding balance may decrease over time, the amount that is reported as interest expense does not fluctuate; it remains steady throughout the life of the loan or bond. The effective interest rate method is preferred because it accurately reflects the economic reality of the financial transaction.

For example, if a bond is issued at a discount, the interest expense reported each period will include not just the coupon payment (if any), but also a portion of the discount that is being amortized. As time passes and the book value of the bond approaches its face value, the amount of interest expense reported remains constant, even though the actual cash paid may be different.