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