Under the effective interest method, how is interest expense determined?

• A. It equals the cash interest paid each period.
• B. It equals the carrying amount times the effective rate; amortizes premium/discount over life.
• C. It equals the coupon rate times par value.
• D. It uses straight-line method.

Answer: (D)

Under the effective interest method, interest expense for a period is calculated by multiplying the carrying amount of the liability at the beginning of the period by the instrument’s effective interest rate. This keeps the effective rate constant over the life of the debt. The cash interest payment (coupon rate times par value) can differ from this expense if the instrument was issued at a premium or a discount. The difference between interest expense and cash interest is the amortization of the premium or discount, which adjusts the carrying amount each period. If issued at a premium, the premium is amortized and interest expense is less than cash interest; if issued at a discount, the discount is amortized and interest expense is greater than cash interest. Over time, the carrying amount moves toward the par value.