Effective interest rate
The effective interest method uses this rate to allocate interest income or expense and relevant transaction costs, premiums and discounts over time. For most financial assets interest is calculated on the gross carrying amount; credit-impaired assets and purchased or originated credit-impaired assets have particular rules. Estimate cash flows consistently with the instrument’s terms, including relevant fees, and distinguish the effective rate from the stated coupon.
Worked example
An entity issues a one-year debt instrument for net proceeds of $950 and must repay $1,000 in one year. With no other cash flows, its effective rate is $50 ÷ $950 = 5.263%; the $50 finance cost increases the liability to $1,000.
Common mistake
Using the nominal coupon as the effective rate when issue costs or discounts change the actual proceeds, or treating the entire fee as an annual charge.
Where it appears in your exams
| Qualification | Exam | Relationship | Period |
|---|---|---|---|
| ACCA | FR | Direct | September 2026–June 2027 |
| ACCA | SBR | Direct | September 2026–June 2027 |
