Question

When interest expense is calculated using the effective-interest amortization method, interest expense (assuming that interest is paid annually) always equals the?

Answer 1

Interest expense calculated with the effective-interest amortization method equals the beginning period book value of the debt times the effective interest rate, causing interest expense to change over time.

Step-by-step explanation:

When interest expense is calculated using the effective-interest amortization method, interest expense always equals the product of the book value of the debt at the beginning of the period and the effective interest rate. Unlike the straight-line method where interest expense remains constant, the effective-interest method reflects that interest expense changes as the book value of the debt changes due to amortization.

For example, consider a bond with a face value of $1,000, a 5% stated interest rate, and a market rate at issuance of 6%. The bond would be issued at a discount. Over time, interest expense is recognized not only on the cash paid out but also on the increasing book value of the bond, until maturity when the book value equals the face value.