Financial Instruments

Its basically an application of faithful representation in the accounts.The effective rate is the actual economic rate an entity is undertaking.For example, if a company issues a bill agreeing to pay a lender one hundred and twenty one thousand dollars in two years time in exchange for one hundred thousand dollars now it will have created a liability.The effective rate of interest it will pay on this liability is ten per cent per year.On initial issue of loan note company should record cash received of hundred thousand dollars and also liability of hundred thousand dollars.After one year effective interest of ten thousand dollars should be charged to profit and loss and also added to existing liability creating liability of one hundred and ten thousand at year end.This is despite fact no actual cash flow has been made.