Financial Accounting: In an Economic Context

ACCOUNTING FOR LONG-TERM OBLIGATIONS: THE EFFECTIVE INTEREST METHOD

Understanding the effective rate of interest is important because it represents the actual rate of interest associated with an obligation. It is the foundation for the effective interest method, which is used to account for long-term contractual obligations- notes, bonds, and capital leases. This method consists of one basic rule:

The interest expense reported during each period of a long-term obligation's contractual life is computed by multiplying the effective interest rate by the balance sheet value of the obligation as of the beginning of the period.

The rationale underlying the effective interest method is that it leads to an interest expense amount each period that reflects the actual interest being paid on the obligation. In addition, it guarantees that the long-term liability on the balance sheet (note payable, bond payable, or lease liability) is reported throughout its life at the present value of its future cash flows, discounted at the effective interest rate. Recall from the discussion in Chapter 4 that present value is the theoretical goal of financial measurement.

At the end of 2008, Sherwin Williams reported long-term debt of $304 million on its balance sheet. At an average effective interest rate of 7.45 percent, estimate the interest expense associated with this debt reported by the company on ...