IFRS Masterclass blog

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IFRS 9 Amortized Cost Method | Concept and Example

Oct 10, 2024

Here is a quick and easy refresher of Amortized cost and effective interest rate.

Why do we use Amortized cost method?

The textbook answer is because IFRS 9 said so.

The conceptual answer is that the amortized cost method helps spread costs or income in a way that reflects their true financial impact over time. This method is commonly used for loans and bonds.

To be more specific, amortized cost method is used when a financial asset:

has cash flows that are solely payment of principal and interest and
is held to collect contractual payments

Here's a detailed example of amortized cost accounting under IFRS 9:

Example Scenario: Entity D's Bond purchased at a discount

Loan Details:

Principal Amount (Par Value): $10,000
Annual Coupon Rate: 8%
Loan Term: 4 years
Payment Frequency: Annual
Issuance Price: $9,000 (issued at a discount of $1,000)

Initial Recognition:

The bond is recorded at the issuance price:

Initial Loan Balance=$9,000

Note that despite the par value (face value) of the bond is $10,000, the purchase price (and fair value) is $9,000. The bond is recorded in the books at the fair value.

Cash Flow Schedule (Coupon payments):

Annual interest payment: 10,000×8%

Note that the coupon are based on the par value and not on the fair value.

If you are thinking why par value is different from fair value, this is because the coupon payments are fixed, and market interest rates keep changing. So when we discount fixed contractual payments at the market rate, we come up with the fair value that is different form face value.

Think of it this way: if the market rate is 16% no one will pay $10,000 for a bond that pays only $800 per annum.

You get my point?

And this leads us to EIR.

Effective Interest Rate (EIR):

The EIR is calculated using the cash flows:

Here are the contractual cash flows:

Amortization Schedule: The amortization schedule would look as follows:

Key Points:

Interest Expense: Each year, the interest expense is calculated using the opening balance multiplied by the EIR (15.74% in this example).
Closing Balance: Each closing balance is the previous year's closing balance plus the interest expense minus the cash flow (interest payment).
Final Payment: In the last year, the cash flow includes both the final interest payment and the repayment of the principal (face value in this case which is different from fair value).

This example illustrates the treatment of a loan issued at a discount under IFRS 9, showing the impact on cash flows and interest calculations over the loan term.

Now let's look at the accounting entries at initial recognition and subsequent measurement.

Initial Recognition (Bond Purchase):

Initially, the bond is recognized on the fair value paid.

Debit: Bond Investment $9,000
Credit: Cash $9,000

Subsequent Measurement

Subsequently, $800 of coupon/ cash is received every year. But the interest income is determined by effective interest method. In year 1, the interest earned is 15.74% of the opening balance $9,000, which is $1,417. Out of this $1417 earned, $800 is received in cash as coupon, the rest adds to the carrying value of the bond.