The interest method is used throughout U.S. GAAP (and IFRS) financial statements, but do you understand how this method actually works under ASC 835, Interest? This post highlights the key aspects of our CPE-eligible, eLearning course on the Interest Method and Effective Interest Rates.
What is it?
First, let’s set the record straight…the technical terminology is the “interest method”; however, you may have heard this method referred to as the “effective interest method” or the “effective yield method” – we’re all talking about the same thing!
The Financial Accounting Standards Board’s (FASB) Master Glossary defines the interest method as “the method used to arrive at a periodic interest cost, including amortization, that will represent a level effective rate on the sum of the face amount of the debt and the unamortized premium or discount and expense at the beginning of the period.” Straightforward, right?!
Said more simply, the interest method is the method preferred by U.S. GAAP to amortize premiums, accrete discounts, and properly split the portion of a payment between interest and principal for proper recognition of interest income or expense.
For certain financial instruments, U.S. GAAP requires entities to defer the recognition of fees, costs, premiums, and discounts over time instead of recognizing these items initially. These items are recognized over the life of the asset or liability by using the effective interest rate when applying the interest method. The effective interest rate is the rate implicit in the asset or liability and will need to be calculated.
While the interest method is formally defined in the Master Glossary, different topics throughout the FASB’s Accounting Standards Codification (ASC) refer to the interest method. ASC 835, Interest details the application of the interest method.
Where is it used
The interest method is applicable to assets and liabilities that have interest income or expense that is required to be recognized. Below are four key areas where the interest method is used, but beware – this list is not all inclusive!
Debt securities: The differences in the face value, or par value, of the investment and what the purchase price paid by the investor are referred to as premiums and discounts. The premium or discount, combined with the stated interest rate, can be thought of as compensation for the time value of money and the credit risk taken on by the investor.
The premium and discount impact the amount of cash exchanging hands between the debt security issuer and investor; therefore, this difference must be accounted for by the investor using the interest method. U.S. GAAP requires premiums to be amortized over the life of the debt investment security, and if the debt security is purchased at a discount, this amount is accreted each period as an increase to interest income over the life of the security.
Loan receivables: When an entity makes a loan to a customer, U.S. GAAP requires interest income to be accrued and credited to interest income as it is earned, using the interest method. GAAP also requires the deferral of certain fees and costs associated with the origination of a loan over the life of the loan. We discuss which fees and costs should be deferred and which should be immediately recognized in our Banking Industry Fundamentals: Loans course. The stated interest rate, and these deferred items must all be considered in determining the effective interest rate to apply the interest method. You may be familiar with this being called the loan’s “yield.”
Debt issuance: Similar to investments above, any discounts or premiums on debt issued by an entity must be recognized over time using the interest method.
Lease liability for lessees under ASC 842: The interest method is utilized when amortizing interest expense associated with the lease liability.
How to apply the interest method
Not so fast…before we can start applying the interest method, we need a key input – the effective interest rate. The effective interest rate is the rate implicit in the asset or liability that is the contractual interest rate adjusted for any net deferred fees and costs, premiums or discounts, and debt issuance costs. Basically, this rate encapsulates all of the items required under U.S. GAAP to be deferred and recognized over the life of the asset or liability.
Would an example be helpful? How about two?! Our course contains two examples:
- Mortgage loan receivable
- Debt security investment
Each example provides a set of case facts, then walks you through the calculation of the effective interest rate, shows you how to complete each column of the amortization table, and includes journal entries. Even better, the course includes downloadable resources: an effective interest rate calculation example, and the amortization tables completed for both of the above examples.
Banking specific CPE training
The banking industry is one of many industries that uses the interest method prevalently! Did you know we have a whole collection of banking industry-specific courses? We’ve bundled together 10 online, eLearning courses totaling 11.7 CPE credits at a great price, covering all the topics you need to know if you’re responsible for financial reporting for, or auditing of, banks. Check out this post that provides an overview of each course in the collection.
About GAAP Dynamics
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This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
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