Question

Some companies may use the straight-line method of computing interest expense and amortizing the discount or premium, rather than the effective interest method.

i) what is the difference between the two methods?

ii) Why is the straight-line method NOT considered acceptable under US GAAP?

iii) Why do some companies use it anyway, even though it is not acceptable?

Answer 1

i)straight line method of interest calculation:To calculate the interest for each period, simply divide the total interest to be paid over the life of the bond by the number of periods, be it months, quarters, years or otherwise.while in effective interest method is a method to calculate actual interest rate in a period based on the amount of financial instruments book value at the begining of the accounting period.hence if the book value of financial instrument decreases the interest also decreases and vice versa.

ii) under straight line,method of interest calculation it does not considering the any change in book value of financial instruments as it is equally dividing over the useful life the instrument,hence it is not acceptable at all.

iii) following the straight line method of interest calculation is easy as comparing to effective method as it required more calculation work.hence some company is prefering this method. while in point of view of investor straight line method of interest is providing one advantage as interest rate will not decrease in accordance with decrease in book value of financial instrument.