Effective Interest Rate (EIR): Floating (Variable)- Rate Financial Instruments

I have been receiving a number of queries on calculation of effective interest rate for floating (variable) rate financial assets or financial liabilities – which are to be subsequently measured at amortised cost.

Let’s first start with the definition of ‘Effective Interest Method’. Indian Accounting Standard (Ind AS) 109, Financial Instruments in Appendix A states that ‘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 (ECL). 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, 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).’

The definition is lucid and almost explains the calculation of effective interest rate in all the scenarios. The Application Guidance in Appendix B of the standard while elucidating on amortising yield enhancing fees and/or costs over the expected life of financial asset or financial liability mentions EIR of floating (variable) rate instruments. For floating (variable)-rate financial assets or financial liabilities, periodic re-estimation  of cash flows to reflect the movements in the market rates of interest alters the effective interest rate. If the floating (variable)-rate financial asset or financial liability is recognized initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability.

To sum it up, in the floating (variable)-rate financial asset or liability any fees, transaction costs, premiums or discount will be amortised at EIR till the next interest repricing date. If such transaction costs are not material to be included in the EIR calculation then amortised cost of financial asset or financial liability would be the carrying amount.