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The effective interest rate method, or interest method as it is referred to by the FASB in the codification, spreads the total cost of debt over the life of the debt at a constant interest rate.

This constant interest rate is also referred to as the constant interest yield. The constant interest rate includes the contractual interest rate stated in the debt agreement PLUS other borrowing costs such as original issue discount or premium, up-front borrowing costs, and any other costs associated with the debt that should be spread over the life of the debt as interest cost. These can include some rather complicated items when the borrowing is associated with equity-linked components such as warrants or conversion features which may cause recognition of a beneficial conversion feature. All of these costs must be spread over the term of the debt in a manner that yields a constant interest rate. As a result, the actual interest cost may fluctuate from period-to-period as the principle balance changes (which would include accrued interest costs that add to principle!) over time. Once the constant yield rate is set it does not change UNLESS there is a modification of the debt agreement that changes its terms. Any unamortized costs at the time of the modification, plus any costs incurred as a result of the modification, would be spread over the remaining modified term of the debt. This will most likely result in a change to the constant yield rate.

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