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13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

Effective-Interest Method​

Effective-Interest Method:

  • Calculates interest expense based on carrying value
  • Carrying value changes over time (decreases as principal is paid)
  • Interest expense = Carrying Value × Market Rate
  • Payment - Interest Expense = Principal Reduction
  • More accurate than straight-line method

Why Use Effective-Interest:

  • Matches interest expense with carrying value
  • More accurate interest allocation
  • Required by accounting standards
  • Better reflects economic reality

Loan Amortization Schedule​

Example:

  • Loan: €100,000
  • Interest Rate: 6% per year
  • Term: 5 years
  • Annual Payment: €23,739.64

Complete Amortization Schedule:

YearBeginning BalancePaymentInterest (6%)PrincipalEnding Balance
1€100,000.00€23,739.64€6,000.00€17,739.64€82,260.36
2€82,260.36€23,739.64€4,935.62€18,804.02€63,456.34
3€63,456.34€23,739.64€3,807.38€19,932.26€43,524.08
4€43,524.08€23,739.64€2,611.44€21,128.20€22,395.88
5€22,395.88€23,739.64€1,343.76€22,395.88€0.00
€118,698.20€18,698.20€100,000.00

Year 1 Journal Entry:

120000 Long-Term Loan             €17,739.64
660000 Interest Expense            6,000.00
510000 Cash                                    €23,739.64
To record loan payment (Year 1)

Year 2 Journal Entry:

120000 Long-Term Loan             €18,804.02
660000 Interest Expense            4,935.62
510000 Cash                                    €23,739.64
To record loan payment (Year 2)

Pattern:

  • Interest expense decreases each year (as balance decreases)
  • Principal payment increases each year
  • Total payment remains constant
  • Loan balance decreases to zero

Straight-Line Method (Not Preferred)​

Straight-Line Method:

  • Allocates interest equally over term
  • Simpler but less accurate
  • Not recommended for long-term liabilities
  • Doesn't reflect actual interest cost

Example (Not Recommended):

  • Total Interest: €18,698.20
  • Annual Interest: €18,698.20 ÷ 5 = €3,739.64
  • Same each year (inaccurate)

Luxembourg Compliance Note​

Effective-interest method in Luxembourg:

  • Must be used for proper interest allocation
  • Must comply with accounting standards
  • Interest expense affects taxable income
  • Must maintain amortization schedules
  • Must use proper PCN accounts
  • Must separate current and long-term portions

Journal Entries​

Year 1 Payment:

120000 Long-Term Loan             €17,739.64
660000 Interest Expense            6,000.00
510000 Cash                                    €23,739.64
To record loan payment

PCN Accounts:

  • 120000: Long-Term Loans (Emprunts)
  • 660000: Interest Expense (Intérêts)
  • 510000: Cash (Trésorerie)

Luxembourg Compliance Note​

Effective-interest method in Luxembourg:

  • Must be used for proper interest allocation
  • Must comply with accounting standards
  • Interest expense affects taxable income
  • Must maintain amortization schedules
  • Must use proper PCN accounts

Think It Through​

Why is the effective-interest method preferred over the straight-line method for amortizing long-term liabilities?