Amortised cost and the effective interest method

Amortised cost and the effective interest method

This narrative explores the factors that an entity needs to consider in calculating the amortised cost of a financial asset or financial liability and recognising interest revenue and expense based on the effective interest rate (EIR).

Calculating amortised cost

The amortised cost of a financial asset or financial liability is calculated in the same way as under IAS 39, although IFRS 9 introduces the concept of ‘gross carrying amount’ for financial assets. The gross carrying amount is the amortised cost grossed up for the impairment allowance. The elements of amortised cost are illustrated below.

Financial assets

Financial liabilities

Fair value at initial recognition

At recognition a loan receivable or payable is recognised at fair value measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (currency, term, etc.) with a similar credit rating.

MINUS

Principal redemptions/repayments

ADD

Periodical interest income based on the effective interest method

Periodical interest expense based on the effective interest method

MINUS

Gross carrying amount

N/A

Loss allowance

= Amortised costs

= Amortised costs

(no adjustment for loss allowance)

Calculating the EIR

1. General approach

The EIR is calculated at initial recognition of a financial asset or a financial liability. It is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to:Amortised cost and the effective interest method

  • the gross carrying amount of the financial asset; or
  • the amortised cost of the financial liability.

At initial recognition, the gross carrying amount of a financial asset, or the amortised cost of a financial liability, is generally equal to the fair value of the instrument, adjusted for transaction costs (see Reclassification of financial assets).

The estimate of expected cash flows considers all contractual terms (e.g. prepayment, call and similar options) but does not consider expected credit losses (i.e. the contractual cash flows are not reduced by expected credit losses).

1.1 Floating-rate financial instruments

For floating-rate financial instruments, the EIR is altered by periodic re-estimations of cash flows to reflect movements in market rates of interest. (IFRS 9.B5.4.5) Amortised cost and the effective interest method

Food for thought – Calculating the EIR for floating-rate financial instruments

IFRS 9 does not specify how to calculate the EIR for floating-rate financial instruments. Therefore, it appears that applying the new standard will not change current practice (developed under IAS 39), which seems to allow two approaches for calculating the EIR.

  • Approach 1: Based on the actual benchmark interest rate that was set for the relevant period.
  • Approach 2: Taking into account expectations of future interest rates, and changes in these expectations.

This is illustrated by the following case.

Case – Calculating the EIR for floating-rate financial instruments

Company X issues at par a financial liability with:

  • principal of 100;
  • a contractual interest rate of 12-month LIBOR plus 2% (payable annually); and
  • a maturity of three years.

12-month LIBOR at initial recognition of the liability is 2% and is used to set the first annual coupon. 12-month LIBOR is expected to be 3% in Year 2 and 4% in Year 3.

Approach

Calculation of initial EIR

1

The initial EIR is calculated as 4% per annum – i.e. 12-month LIBOR at initial recognition plus the margin of 2%.

2

The initial EIR is calculated as approximately 5% per annum – i.e. the IRR of the following cash flows:

  • expected coupons of 4, 5 and 6; and
  • principal repayable at maturity of 100.
1.2 Fees that are an integral part of the EIR or not

IFRS 9 incorporates the guidance on financial service fees (both received and paid) that are an integral part of the EIR of a financial instrument. IFRS 9 also includes examples of fees that are not an integral part of the EIR, which are accounted for under IFRS 15. (IFRS 9.B5.4.1–3) Amortised cost and the effective interest method

Food for thought – Fees that are an integral part of the EIR

  • Origination fees received by the entity relating to the creation or acquisition of a financial asset. Such fees may include compensation for activities such as evaluating the borrower’s financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating the terms of the instrument, preparing and processing documents and closing the transaction. These fees are an integral part of generating an involvement with the resulting financial instrument.
  • Commitment fees received by the entity to originate a loan when the loan commitment is not measured in accordance with IFRS 9.4.2.1(a) and it is probable that the entity will enter into a specific lending arrangement. These fees are regarded as compensation for an ongoing involvement with the acquisition of a financial instrument. If the commitment expires without the entity making the loan, the fee is recognised as revenue on expiry.
  • Origination fees paid on issuing financial liabilities measured at amortised cost. These fees are an integral part of generating an involvement with a financial liability. An entity distinguishes fees and costs that are an integral part of the effective interest rate for the financial liability from origination fees and transaction costs relating to the right to provide services, such as investment management services.

Food for thought – Fees that are not an integral part of the EIR

  • Fees charged for servicing a loan;
  • Commitment fees to originate a loan when the loan commitment is not measured in accordance with IFRS 9.4.2.1(a) and it is unlikely that a specific lending arrangement will be entered into; and
  • Loan syndication fees received by an entity that arranges a loan and retains no part of the loan package for itself (or retains a part at the same effective interest rate for comparable risk as other participants).

2 Credit-adjusted EIR

The EIR for purchased or originated credit-impaired financial assets (‘POCI’ assets) is calculated slightly differently than under the general approach (see Initial measurement credit-impaired financial assets). For POCI assets, the EIR is calculated using expected cash flows inclusive of future lifetime expected credit losses – i.e. the estimated contractual cash flows are reduced by lifetime expected credit losses. (IFRS 9.B5.4.7) Amortised cost and the effective interest method

The resulting EIR is defined as the credit-adjusted EIR. For the defining description of a credit-impaired asset use this link. Amortised cost and the effective interest method

Food for thought – Calculation of EIR for POCI assets

Under IFRS 9 the EIR includes all expected future credit losses. Although under IFRS 9 the calculation of EIR for POCI assets reflects all expected credit losses rather than just incurred credit losses, this may not in practice result in a big change in the EIR for these assets as compared with IAS 39. This is because once an asset is impaired, it may be difficult in practice to distinguish between incurred and expected credit losses.

3 Calculating interest revenue and expense using the EIR

3.1 General approach

Under IFRS 9, the EIR is used to allocate interest revenue or expense over the expected life of the financial instrument in a similar manner to that under IAS 39. (IFRS 9.B5.4.4) Amortised cost and the effective interest method

Generally, interest revenue and expense are calculated as follows (IFRS 9.5.4.1). Amortised cost and the effective interest method

Revenue

Apply the EIR to the gross carrying amount of a financial asset.

Expense

Apply the EIR to the amortised cost of a financial liability.

3.2 Approach for credit-impaired financial assets

For credit-impaired financial assets, interest revenue is calculated by applying the EIR (or credit-adjusted EIR if the asset was credit-impaired at initial recognition) to the amortised cost of the asset. An asset could be credit-impaired if (IFRS 9.5.4.1(a)–(b)): Amortised cost and the effective interest method

  • it was credit-impaired on initial recognition (a POCI asset); or Amortised cost and the effective interest method
  • it became credit-impaired after initial recognition. Amortised cost and the effective interest method

For an asset that became credit-impaired after initial recognition, the calculation of interest revenue reverts to the gross basis if the asset is no longer credit-impaired. However, for POCI assets, the calculation of interest revenue can never revert to a gross basis, even if the credit risk of the asset improves (IFRS 9.5.4.1(a), IFRS 9.5.4.2).

Food for thought – Applying the EIR to the gross carrying amount or amortised cost of a financial asset

The requirements of IFRS 9 to calculate interest revenue for credit-impaired assets by applying the EIR to the amortised cost of a financial asset are the same as the former IAS 39 requirements for all financial assets and financial liabilities.

However, for assets that are not credit-impaired an apparent difference arises between the requirements of IFRS 9 and IAS 39. This is because under IFRS 9, an asset attracts an impairment allowance even if it is not credit-impaired (see the expected credit losses concept).

Therefore, under IFRS 9 interest revenue on these assets is calculated by applying the EIR to the gross carrying amount – i.e. the amortised cost grossed up for the impairment allowance. By contrast, under IAS 39 interest revenue is always calculated by applying the EIR to amortised cost but no impairment allowance is recorded for assets that are not credit-impaired.

4 Revisions to estimated cash flows

When an entity revises its estimate of payments or receipts from a financial asset or financial liability, it recalculates the gross carrying amount of the financial asset or the amortised cost of the financial liability to reflect the revision. The revised gross carrying amount of the asset (or amortised cost of the liability) is equal to the present value of the revised estimate of cash flows, discounted at the asset’s EIR. The adjustment is recognised in profit or loss as income or expense (IFRS 9.B5.4.6). Amortised cost and the effective interest method

Food for thought – No definition of ‘floating-rate financial instrument’

IFRS 9 retains the guidance in IAS 39 on accounting for revisions to estimated cash flows that are receivable or payable under financial assets and financial liabilities. IFRS 9 also retains the guidance in IAS 39 on amending the EIR of floating-rate financial instruments but, similar to IAS 39, does not define the term ‘floating-rate financial instrument’ (IFRS 9.4.1.3, B4.1.7A, B5.4.5–6, IAS 39.AG7–AG8).

IAS 39’s lack of guidance in this area has led to a debate as to whether certain instruments with contractual resetAmortised cost and the effective interest method features – e.g. indexation to inflation or an entity’s revenue – should be considered floating-rate financial instruments such that the EIR is subject to alteration for resets (see Floating-rate financial instruments), or whether the entire effect of resets should instead be reflected by remeasuring the present value of contractual cash flows at the unchanged original EIR.

A submission on this matter was made to the IFRS Interpretations Committee in July 2008, and the IASB discussed the issue in its October 2009 meeting.

For financial assets, the classification and measurement requirements of IFRS 9 restrict amortised cost measurement to assets whose contractual terms give rise to cash flows that are ‘solely payments of principal and interest’, consistent with a basic lending arrangement (see the SPPI Test).

This means that assets containing certain features – e.g. indexation to revenue – do not qualify for amortised cost treatment, and so for these assets entities will not have to determine whether those features could be viewed as floating-rate interest.

However, this determination may still be relevant for some types of reset feature – e.g. indexation to inflation – for financial assets that may satisfy the SPPI criterion (see Examples of financial instruments that may not meet the SPPI test) and for financial liabilities.

5 Modifications of financial assets

5.1 Overview

IFRS 9 introduces guidance on (IFRS 9.5.4.3): Amortised cost and the effective interest method

  • measuring the amortised cost of financial assets that have been modified, when the modification does not result in derecognition; and Amortised cost and the effective interest method
  • recognising the resulting gains or losses. Amortised cost and the effective interest method

This guidance applies to all modifications, irrespective of the reason for the modification.

Food for thought – Derecognition of a modified financial asset

IFRS 9 retains the guidance in IAS 39 that a financial asset is derecognised when the contractual rights to its cash flows expire. However, there is no specific guidance in IAS 39 on how this criterion should apply for modifications of financial assets (IFRS 9.3.2.3(a)).

A submission on this matter was made to the IFRS Interpretations Committee. The Committee discussed this issue in September 2012 in the context of the narrow fact pattern included in the submission. In its agenda decision, the Committee noted that to assess whether a financial asset was extinguished, an entity needs to assess:

  • the changes made to the terms of the asset; against
  • the notion of ‘expiry’ of the rights to the cash flows.

The Committee also noted that, in the absence of an explicit discussion in IAS 39 on when a modification of a financial asset results in derecognition, an analogy might be made to the guidance on modifications of financial liabilities in IAS 39, under which a substantial change of terms would result in derecognition.

This guidance, which is also carried forward unchanged into IFRS 9, states that the terms are substantially different if the discounted present value of the cash flows under the new terms using the original EIR is at least 10 percent different from the discounted present value of the remaining cash flows of the original financial liability (IFRS 9.B3.3.6, IFRS 9.B5.5.25–26, IFRS 9.IE68–IE69).

This agenda decision only referred to the specific fact pattern in the submission, and the Committee decided not to add the issue to its agenda.

IFRS 9 does not provide a comprehensive analysis of the matter, but does:

  • state that, in some circumstances, the renegotiation or modification of the contractual cash flows of a financial asset can lead to the derecognition of the existing financial asset;
  • refer to ‘a substantial modification’ of a distressed asset as an example of a modification that results in derecognition; and
  • include an example for modification that does not result in derecognition, in which the gross carrying amount of the modified asset is 30 percent lower than the original loan.

Food for thought – Scope of the guidance on modification of financial assets

Some respondents to the 2013 impairment ED6 suggested that the scope of the modifications guidance should be limited and aligned to the definition of forbearance proposed by the European Banking Authority (EBA). The EBA’s final draft defines forbearance as measures that: “consist of concession towards a debtor facing or about to face difficulties in meeting its financial commitments”.

However, the IASB decided not to limit the application of the guidance. One reason for this decision was because it may be operationally difficult to determine the purpose of the modification – i.e. whether it is performed for commercial or credit risk management reasons. Therefore, IFRS 9 does not define the term ‘modification’, but discusses it in the wider context of any changes to contractual terms (IFRS 9.BC5.231–232, IFRS 7.BC48Z).

5.2 Gains or losses on modifications of financial assets

For modifications that do not result in derecognition, the gross carrying amount of the asset is recalculated by discounting the modified contractual cash flows using the EIR before modification. Amortised cost and the effective interest method

Any difference between this recalculated amount and the existing gross carrying amount is recognised in profit or loss as a modification gain or loss. Any costs or fees incurred as part of the modification adjust the carrying amount of the modified financial asset, and are amortised over the remaining term of the modified financial asset (IFRS 9.5.4.3).

Case – Gain or loss on modifications that do not result in derecognition

A bank may modify the terms of loans with good credit quality for business reasons. For example, a borrower whose credit quality has improved may approach the bank to reduce the margin, and the bank may agree in order to preserve the relationship and to reflect the improved credit risk. If the modification does not result in derecognitionAmortised cost and the effective interest method of the original loan, the new standard requires the bank to recognise an immediate loss on this transaction.

This is because the recalculated carrying amount of the loan will be equal to the net present value of the modified – i.e. reduced – cash flows discounted at the original EIR.

In another example, a bank may extend the maturity of a loan of a good customer to meet the customer’s business needs, and increase the interest rate to reflect market rates for the extended maturity.

If the modification does not result in derecognition of the original loan, the new standard requires the bank to recognise an immediate gain on this transaction. This is despite the fact that there is no economic gain for the bank, because the increased interest reflects market rates for the extended period and is intended to compensate the bank for increased risk.

Food for thought – Gain or loss on modifications that do not result in derecognition

Overall impact on profit or loss

Modifications of a financial asset that do not result in derecognition may impact profit or loss in two ways:

  • by recognising the modification gain or loss that is equal to the change in the gross carrying amount of the modified financial asset; and
  • by changing the amount of expected credit losses recognised as an impairment allowance (see 12.4). For example, if modification resulted in a reduction in contractual cash flows, then the expected cash shortfalls would also be likely to reduce.

In many cases, this impact may be offsetting – e.g. when a modification results in a reduction in the contractual amount of a debt that reflects the debtor’s assessed inability to pay the previous full contractual amount. In such cases, an entity may also have to assess whether the gross carrying amount of the financial asset should be partially written off before the modification, thereby reducing the gross modification gain or loss at the time of modification (see 12.5).

Presentation of gain or loss on modifications that do not result in derecognition

There is no guidance in IFRS 9 on the line item in the statement of profit or loss and OCI in which gains or losses on the modification of financial assets should be presented.

A modification gain or loss may not necessarily relate to impairment (see Impairment of financial assets), because not all modifications are performed for credit risk reasons. Accordingly, entities will have to exercise judgement to determine an appropriate presentation for the gain or loss.

Modifications that do not result in derecognition – costs or fees incurred

IFRS 9 states that costs or fees incurred as part of the modification are amortised over the remaining term of the modified financial asset. However, there is no specific guidance in the standard on the basis of this amortisation. Because these costs or fees adjust the carrying amount of the asset as part of the amortised cost remeasurement, it appears that the EIR will need to be adjusted following the modification for the purposes of amortisation.

Modifications that do not result in derecognition – application to financial liabilities

IFRS 9 does not amend the guidance on modifications of financial liabilities that do not result in derecognition. Accordingly, the new standard does not specify the accounting treatment for an increase or decrease in the present value of contractual cash flows arising from a modification of a liability that does not result in derecognition – i.e. whether a modification gain or loss should be calculated in a similar manner to that for financial assets.

However, the standard has amended the wording of the general guidance on revisions of estimates of cash flows (see Revision to estimated cash flows) to state that modifications of financial assets are excluded from its scope. The basis for conclusions indicates that the Board may have intended that the guidance in 4 Revisions of estimated cash flows would apply to modifications of financial liabilities that do not result in their derecognition.

If it were applied to these modifications, they would result in gains or losses being recognised in profit or loss, similar to modifications of financial assets (IFRS 9.B3.3.6, IFRS 9.B5.4.6, IFRS 9.BC5.233, IAS 39.AG8).

If a modification results in derecognition, then the modified financial asset is recognised as a new financial asset (IFRS 9.B5.5.25). Amortised cost and the effective interest method

Food for thought – Gain or loss on modifications that result in derecognition

Because the modified asset is recognised as a new financial asset, this means that the new asset is initially measured at its fair value plus eligible transaction costs. The standard does not discuss to what extent costs and fees incurred may be eligible for capitalisation as transaction costs attributable to the origination of the new asset, as opposed to being considered amounts that should be expensed in relation to the derecognition of the old asset.

This is in contrast to modifications of financial liabilities that result in derecognition, for which the new standard states that any costs or fees incurred are recognised as part of the gain or loss on extinguishment. Ignoring any such fees and costs, derecognition effectively results in an overall gain or loss equal to the difference between:

  • the amortised cost of the old asset; and
  • the fair value of the new asset minus the amount of expected credit losses initially recognised as an impairment allowance on the new asset (see Modified financial assets).

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Amortised cost and the effective interest method

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