What is Amortized Cost Method?
The amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance.
Amortized Cost= Initial Recognition Amount -Principal repayment ± Cumulative Amortization (using EIR)- Loss Allowance
Effective interest method
The method that is used in the calculation of the amortized cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period.
A financial asset shall be measured at amortized cost if both of the following conditions are met:
- The financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows (BMT Test) and
- The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (CCFT/SPPI Test)
Steps involved in classification & Measurement
- Initial Recognition: - Fair Value+ Transaction cost
- Determine Effective Interest Rate (EIR)
- The discount rate that equates all future cash flows (principal + interest) to the instrument’s initial carrying amount.
- If reliable estimation of expected cash flows is impossible, use contractual cash flows over the full term.
Initial Cost = ∑ Cash Flow /(1+r) ^t, Determine r, (use IRR or trial and error.)
- Calculate interest Income.
Lets Understand it by an example
Bond Details:
- Face Value: $100,000
- Coupon Rate: 5% (paid annually)
- Term: 3 years
- Purchase Price: $98,000 (at a discount)
- Transaction Costs: $500
Calculate the (EIR).
Prepare an amortization schedule for the bond’s life.
Record journal entries for:
- Initial recognition.
- Year 1 & 2 interest income and amortization.
- Final repayment at maturity.
Solution
Face Value (FV): $100,000
Coupon Rate: 5% → Annual Coupon Payment = 100,000×5100,000×55,000**
Purchase Price: $98,000
Transaction Costs: 500
Initial Carrying Amount = =98,000 + 500=98,500
Cash Flows:
- Year 1: $5,000
- Year 2: $5,000
- Year 3: 105,000(105,000(100,000 principal + $5,000 coupon).
Calculate EIR based on
98,500=5,000/(1+r)^1+5,000/(1+r)^2+105,000/(1+r)^3
Method 1:
Solve for EIR (Trial and Error)
- Test r = 6%:
5,000/1.06+5,000/1.06^2+105,000/1.06^3= 4,717+4,450+88,166 =97,333
- Test r = 5.5%:
5,000/1.055+5,000/1.055^2+105,000/1.055^3=4,739+4,492+89,531=98,762,
- Test r = 5.6%: and so, on calculate near rate.
Method 2 Calculate in Excel: - by using IRR function
| Year | Cash Flow |
|---|---|
| Initial cost | -98500 |
| 1 | 5000 |
| 2 | 5000 |
| 3 | 105000 |
=IRR (values, guess), =IRR(all vales above, first guess rate, lets5)= 5.56 % is EIR
Calculate Amortization Schedule by using EIR
| Year | Opening Balance | Interets Income@EIR | Amount Received | Amortisation | closing Balance |
|---|---|---|---|---|---|
| 1 | 98,500.00 | 5,476.60 | 5,000.00 | 476.60 | 98,976.60 |
| 2 | 98,976.60 | 5,503.10 | 5,000.00 | 503.10 | 99,479.70 |
| 3 | 99,479.70 | 5,520.30 | 1,05,000.00 | 520.30 | 0.00 |
Journal Entries
| Initial Recognition | Journal | Debit ($) | Credit ($) | |
|---|---|---|---|---|
| Bond Investment | 98,500 | |||
| Cash | 98,500 | |||
| Year 1 Interest Accrual | ||||
| Interest Receivable | 5,476.60 | |||
| Interest Income (P&L) | 5,476.60 | |||
| Year 1 Coupon Receipt | ||||
| Cash | 5,000 | |||
| Interest Receivable | 5,000 | |||
| Year 1 Amortization | ||||
| Bond Investment | 476.6 | |||
| Interest Income (P&L) | 476.6 | |||
| Year 2 Interest Accrual | ||||
| Interest Receivable | 5,503.10 | |||
| Interest Income (P&L) | 5,503.10 | |||
| Year 2 Coupon Receipt | ||||
| Cash | 5,000 | |||
| Interest Receivable | 5,000 | |||
| Year 2 Amortization | ||||
| Bond Investment | 503.1 | |||
| Interest Income (P&L) | 503.1 | |||
| Year 3 Interest Accrual | ||||
| Interest Receivable | 5,520.30 | |||
| Interest Income (P&L) | 5,520.30 | |||
| Year 3 Principal + Coupon | ||||
| Cash | 1,05,000 | |||
| Bond Investment | 1,00,000 | |||
| Interest Receivable | 5,000 | |||
| Year 3 Amortization | ||||
| Bond Investment | 520.3 | |||
| Interest Income (P&L) | 520.3 |
Notes on effective interest rate As per IFRS
The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability.
When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see paragraphs B5.4.1–B5.4.3), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).
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