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Financial Accounting: In an Economic Context by Jamie Pratt

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EFFECTIVE INTEREST RATE

The effective interest rate is the actual interest rate paid by the issuer of the obligation. It may or may not equal the interest rate stated on the contract (for interest-bearing notes). It is determined by finding the discount rate that sets the present value of the obligation's cash outflows equal to the fair market value (FMV) of that which is received in the exchange.3 When contractual obligations are exchanged for cash (1A, 2A, and 3A in Figure 11-2), the cash amount received represents the FMV of the receipt. When contractual obligations are exchanged for noncash items (1B, 2B, and 3B), the FMV of the noncash items must be determined through appraisals or some other means.4 The following examples show how the effective interest rate is determined for the three notes illustrated earlier: installment, non-interest-bearing, and interest-bearing.

imageIn its 2008 annual report, Hewett-Packard listed nearly $14 billion in long-term debt, with annual interest rates ranging from 3.75 percent to 8.63 percent. The long-term debt includes notes, bonds, and leases. Consider these three types of long-term debts and discuss whether you think they are interest-bearing, non-interest-bearing, or installments. Are the interest rates indicated above stated rates or effective rates? Discuss.

Installment and Non-Interest-Bearing Obligations

Assume that Able Company entered ...

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