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.
