Amortized Cost and Effective Interest Rate: What are They?

What is meant by Amortized Cost?

Amortized Cost can be defined as the amount at which certain assets and liabilities are measured at initial cost, adjusted for principal repayments. They comprise of a number of things, which mainly include the following:

  • Initial Recognition Amount
  • Subsequent Recognition of Interest Income and Expense
  • Repayments
  • Credit Losses

Amortization cost can therefore be a classification category and the accounting method that requires financial assets to be classified under this method. Subsequently, the declared amounts are then disclosed in the financial statements at the amortized cost.

The net value at which the assets are declared constitutes the initial acquisition amount, adjusted for principal repayment plus (/minus) any foreign exchange differences that might be applicable.

Criteria for Amortized Cost Classification

Amortized Cost is considered to be one of the presentation categories that are allowed under IFRS 9. Other presentation categories include fair value through Income statements, and fair value through comprehensive income.

Amortized Cost Classification is applicable for debt instruments that meet the following criteria:

  • The business model of the relevant organization that owns the financial assets is primarily based on collecting the contractual cash flows, and not selling the assets to realize any capital gains, whatsoever.
  • The contractual cash flows of specific financial asset under consideration are primarily on the account of repayment of principal and interest. This means that these assets involve both, a principal component, as well as repayments. These repayments occur on specific dates only, i.e. at the end of the year, or at given dates.

What is meant by Effective Interest Rate?

Effective Interest Rate is defined as the rate using which estimated future cash flows are discounted. This is done through the expected life of a certain asset and the gross carrying amount of a financial asset or the amortized cost of financial liability. Gross carrying amount can be further defined as the amortized cost of a financial asset before any loss allowances are adjusted for.

See also  Accounts Payable Vs. Accounts Receivable: 7 Differences You Should Know

The effective Interest Rate method is used in the calculation of the amortized cost of financial assets and liability, towards the allocation and subsequent recognition of the interest revenue or interest expense in the Income Statement for the relevant period. 

Explanation of Effective Interest Rate

For Effective Interest Rate to be applicable, the financial assets should have a fairly predictable cash flow stream that involves both interests, as well as principal repayments. This refers to the interest rate at which the bond is supposed to render periodic interest payments.

However, there is a difference between the effective interest rate (i.e. the market interest rate) and the coupon rate. Therefore, the actual price of the bond is also meant to change as a result.

If the market interest rate is higher than the rate stated on the bond, the market price of the bond is lower than the face value. In the same manner, if the market interest rate is lower than the rate stated on the bond, the market price of the bond is higher than the face value.

In accordance with the accounting standards, financial assets should be recorded in the financial statements at an amortized cost, using an effective interest rate method. Under this method, interest income is calculated using the effective market interest rate (i.e. the prevalent interest rate) to the carrying amount of the bond.

The difference between the interest income recognized and interest income paid is used to classify the discount or premium on the stated financial asset. However, using this method, the discount or the premium at the end of the maturity term works out to be zero. And hence, the face value of the bond also works out to be equal to the face value of the bond.

See also  How Do We Calculate Amortized Loan Cost? Definition, Explanation, and More

Advantage of Using Effective Interest Rate

The primary advantage of using an effective interest rate is the fact that it provides a more accurate figure of the actual interest earned on a certain financial instrument, or investment.

Example of Amortized Cost and Effective Interest Rate

The concept of amortized cost and effective interest rate is illustrated in the following example:

On 1st January 2015, Alpha Inc. invested an amount equivalent to $1,000,000 in Beta Inc. The face value of the bond was $100, with a coupon rate of 6% that was supposed to be paid on an annual basis. The maturity date (time to maturity) of the bond was 10 years. The market interest rate prevalent was around 6.5%.

Using the information presented above, it can be seen that Alpha Inc. acquired 10,000 coupons in Beta Inc. If the market interest was 6.5%, Alpha Inc. would be supposed to pay an amount of $964,055. This is calculated using the Present Value concept, either in Excel or through a financial calculator. The following formula is used for calculation in Excel.

Present Value in Excel= PV (6.5%, 10,-60000,-1000000)

Alpha Inc. is going to record the acquisition of bonds using the following journal entries:

ParticularDebitCredit
Investment (At Amortized Cost)$1,000,000 
 Cash (Present Value of Bond Cash Flows) $964,055
 Discount on Bonds (Amortization Cost)   $35,945

Alpha Inc. is supposed to record the purchase of these bonds at a price of $964,055 in the Balance Sheet. In other words, this is equivalent to the face value of the product, minus the discount. The discount on Company X bonds is considered to be a contra account to the investment asset account.

See also  What is the Allowance Method? (Definition, Calculation, Example, and More )

As far as interest payments are concerned, the first payment would be due in 1 year, from when the bond is issued. The interest payment is going to be calculated as follows:

Interest Payment = ($1,000,000 x 6%) = $60,000

However, this interest payment cannot be recorded as Interest Income by Alpha Inc. because, in accordance with the effective interest method, the initial discount on the bonds should also be accounted for. Therefore, Interest Payment received by Alpha Inc. on the bonds is going to be recorded as follows:

ParticularDebitCredit
Cash ($1,000,000 * 6%)$60,000 
Discount on Bonds $2013 
   Interest Income ($964,055 * 6.5%)   $62,013

After the first payment is made from Beta Inc. to Alpha Inc. the bond value is going to be recorded as follows:

Particular 
Face Value of Beta Inc.’s bonds$1,000,000
Less: Discount on Alpha Inc.’s bonds ($35,945-$2013)$33,932
Amortized Cost of Bonds at the End of the first year$966,068


For the second year, the interest payments are going to be recorded as follows:

ParticularDebitCredit
Cash ($1,000,000 * 6%)$60,000 
Discount on Bonds $2794 
   Interest Income ($966,068 * 6.5%)   $62,794

In the same manner, the amortized cost at the end of the second year would be calculated as follows:

Particular 
Face Value of Beta Inc.’s bonds$1,000,000
Less: Discount on Alpha Inc.’s bonds ($35,945-$2794)$33,151
Amortized Cost of Bonds at the End of the first year$966,849

The same procedure is going to continue for all the years till the maturity date. The amortized cost of the bond at the maturity date is going to equal the actual maturity value, i.e. $1,000,000.

It must be noted that for amortization and effective interest methodology to apply, there is an underlying presumption that cash flows, as well as the expected life of the given assets, can be calculated in a reliable manner.

In other words, this requires companies to ensure that there is no ambiguity pertaining to the amount, as well as the timing of interest payments.

Scroll to Top