Amortized cost is an investment classification category and accounting method which requires financial assets classified under this method to be reported on balance sheet at their amortized cost which equals their initial acquisition amount less principal repayment plus/minus amortization of discount/premium (if any) plus/minus foreign exchange differences (if any) less impairment losses (if any).
Amortized cost is one of the presentation category allowed by IFRS 9, the others being fair value i.e. fair value through profit and loss (FVTPL) and fair value through other comprehensive income (FVOCI).
Amortized cost classification applies predominantly to debt instruments which meet the following criteria:
- The business model of the company which owns such financial assets is to collect the contractual cash flows rather than to sell the asset to realize any capital gains.
- The contractual cash flows of specific financial asset under consideration are on account of repayment of principal and interest and they occur on specified dates.
Effective interest rate method
Financial assets that meet the recognition criteria of the amortized cost, say a bond, carry a specified cash flow stream represented by their coupon rate (also called the stated interest rate) i.e. the rate at which the bond pays periodic interest/coupons. However, since over the term of the bond, the interest rate prevalent in the market differs from the interest rate stated on the bond, the actual market price of the bond also differs from its maturity value. If the market interest rate is higher than the stated interest rate, the bond market price is lower than its maturity value. This is because the bond is offering an interest rate lower than what is prevalent in the market, so such bond sells at a discount. Similarly, if the market interest rate is lower than the stated interest rate on a bond, the bond sells at a premium, i.e. at a price higher than the maturity value of the bond. The only case in which the market price of the bond and its face value are the same is when the market interest rate and the rate stated on the bond are both exactly the same, which is rarely a case.
Accounting standards require that any discount or premium arising on acquisition of a financial asset carried at amortized cost should be amortized using the effective interest rate method. Under the effective interest method, the interest income recognized is calculated by applying the market interest rate to the carrying amount of the bond and the difference between the interest income so recognized and the interest income paid (which equals the product of maturity value of the bond and the stated interest rate) is used to write-off the discount or premium such that the discount or premium is zero at the end of the bond term.
The following example illustrates the application of effective interest rate method.
On 1 January 2015, Drive, Inc. invested in 20,000 Company X bonds whose face value is $100, coupon rate is 6% payable annually and time to maturity is 10 years. If the market interest rate was 6.5%, Drive, Inc. would pay $1,928,112 for these bonds (calculated by discounting the bonds cash flows stream using the market interest rate i.e. using the following Excel Function: PV(6.5%,10,-120000,-2000000).
Drive, Inc. shall record the acquisition of the bonds as follows:
|Investments held at amortized cost—Company X bonds||$2,000,000|
|Cash (present value of bond cash flows)||$1,928,112|
|Discount on Company X bonds||$71,888|
Drive, Inc. shall report the bonds purchased at $1,928,112 on its balance sheet (face value minus discount). The Discount on Company X bonds is a contra-account to the Company X bonds asset account.
The first interest payment is due on 31 December 2015, which shall equal $120,000 (=$2,000,000*6%). However, Drive, Inc. can’t record $120,000 as interest income because according to the effective interest method, it also needs to account for the initial discount on the bonds. It shall record the receipt of first interest payment as follows:
|Discount on Company X bonds||$5,327|
|Interest income ($1,928,112*6.5%)||$125,327|
After the first payment, the value of Company X bonds in books of Drive, Inc. shall be as follows:
|Face value of Company X bonds||$2,000,000|
|Less: Discount on Company X bonds ($71,888-$5,327)||– $66,561|
|Amortized cost of Company X bonds at 31 December 2015||$1,933,439|
The journal entry for the second interest payment i.e. on 31 December 2016 would be as follows:
|Discount on Company X bonds||$5,674|
|Interest income ($1,933,439*6.5%)||$125,674|
Amortized cost at 31 December 2016 would be $1,939,112. This would continue until after the last interest payment, the amortized cost of bonds will be equal to the maturity value i.e. $2,000,000. The following amortization table summarises the application of effective interest rate method over the term of the bond.