AMORTISED COST CALCULATION: THE EFFECTIVE INTEREST RATE (EIR)

IAS 39 mandates some financial assets and liabilities to be subsequently measured at ‘amortized cost’.  This measurement concept is a management theory put in accounting practice. It means that the contractual interest rate each period should be adjusted to amortize the transaction costs over the expected life of the financial instrument. The amortization is calculated on an effective interest rate (EIR) / yield-to-maturity (YTM) basis. The EIR is the rate that exactly discounts the stream of principal and interest cash flows excluding any impact of credit losses, to the initial net proceeds. It is important to note that EIR method does not take into account any future credit impairments anticipated on that instrument.

The carrying amount of the financial instrument subsequently measured at amortized cost is computed as:

Transaction costs are an integral part of the amortized cost calculation. They are defined as costs that are directly attributable to the acquisition, issue or disposal of a financial instrument. Transactions costs are those that are paid to external parties, such as fees and commissions paid to agents, brokers and dealers, levies paid to regulatory agencies, stock exchanges, taxes and duties. Transaction costs may include internal costs, but such costs must be incremental in acquisition, issue or disposal of a financial instrument. Transaction costs will neither include any internal financing, holding and administrative costs nor do they include premium or discount.

Effective Interest Rate Calculation Example

A bank gives a loan to its customer as per the following terms:

Loan Amount: 100,000/-

Maturity: 5 years

Interest: 1^st year – 6%, 2^nd year – 8%, 3^rd year – 10%, 4^th year – 12% and 5^th year 18%

The loan repayments are interest only each year and principal repayment at maturity.

The effective interest rate (IRR) is calculated as the rate that exactly discounts estimated future cash flows through the expected life of the instrument.

100,000 = 6000/ (1+IRR)¹+ 8000/ (1+IRR)² + 10000/ (1+IRR)³ + 12000/ (1+IRR)⁴ + (18000+100000)/ (1+IRR)⁵

Solving this equation on excel we get an IRR = 10.2626%

(Hint: In Excel to calculate EIR use the function XIRR with estimated dates of the expected future cash flows)

The amortized cost of the loan at the end of each period will be accounted as follows:

YEAR	AMORTISED COST AT THE START OF THE YEAR  (A)	EIR (B) = (A) * 10.2626%	CASH FLOW  (C)	AMORTISED COST AT THE END OF THE YEAR             (D) = (A)+ (B) – (C)
1	100,000	10,263	6,000	104,263
2	104,263	10,700	8,000	106,963
3	106,963	10,977	10,000	107,940
4	107,940	11,077	12,000	107,017
5	107,017	10,983	118,000	0