A bond's effective interest rate is the rate that will discount the bond's future interest payments and its maturity value to the bond's current selling price (current market price or present value). The effective interest rate is a bond investor's yield-to-maturity. It is also referred to as the market interest rate. The effective interest rate will likely be different from the stated or contractual rate that appears on the face of the bond.
The accounting profession requires that significant amounts of bond discount or premium be amortized by using the effective interest rate. Under this method, the effective interest rate (at the time the bonds were issued) is multiplied times the bond's carrying value. The result is the amount of interest expense for each reporting period. The difference between this expense and the actual interest paid will be the amount of discount or premium that is being amortized during the reporting period. The effective interest rate method ensures that the interest expense on the income statement will be directly related to the bond amounts on the balance sheet.
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