What is the effective interest rate method?

The effective interest rate method is a technique used to allocate interest expense over time, ensuring that the interest expense recorded reflects the economic reality of the loan or financial instrument. This method calculates interest based on a constant rate applied to the carrying amount of the financial instrument, which includes both the principal amount and any unamortized premium or discount.

Using this approach, payments are divided into two components: interest and principal. The interest portion is computed as a percentage of the carrying amount, while the remainder of the payment reduces the principal. This results in a consistent and logical recognition of interest expense over the life of the financial instrument, aligning with the matching principle in accounting. It reflects the time value of money more accurately than other methods, such as straight-line amortization.

In contrast, other methods mentioned are less reflective of the actual cost of borrowing over time or do not adequately account for varying principal amounts. By focusing on a constant rate applied to the effective carrying amount, the effective interest rate method provides a more comprehensive understanding of the costs associated with financial liabilities.