What is Effective Interest Method?
The effective interest method is an IFRS technique for spreading interest income or expense over the life of a financial instrument so that the carrying amount produces a constant effective yield. It is used for amortised-cost assets and liabilities.
How It Works
- Compute the effective interest rate that discounts the contractual cash flows to the asset’s initial carrying amount.
- Apply the effective rate to the carrying amount at the beginning of each period to compute interest.
- Add the interest to the carrying amount and deduct cash receipts (or vice versa for liabilities).
- Repeat the calculation each period until maturity.
- Disclose the effective rate and the carrying amount movement in the notes.
Saudi Context
Saudi banks and corporates apply the effective interest method to murabaha receivables, sukuk, finance leases, and other amortised-cost instruments under IFRS 9 and IFRS 16 as adopted by SOCPA. ZATCA reviews the resulting interest income for income tax and zakat purposes.
Example
A 3-year sukuk with face value SAR 1,000,000, 5% coupon, issued at SAR 970,000, has an effective rate of about 6.1%. Year-1 interest = 970,000 × 6.1% = SAR 59,170 instead of the SAR 50,000 cash coupon.