9.

2 Amortised cost and effective interest method

9.2.1 Introduction

The amortised cost of a financial asset or financial liability at each reporting date is the net of the following amounts:

(a)the amount at which the financial asset or financial liability is measured at initial recognition;

(b)minus any repayments of the principal;

(c)plus or minus the cumulative amortisation using the effective interest method of any difference between the amount at initial recognition and the
maturity amount; and

(d)minus, in the case of a financial asset, any reduction (directly or through the use of an allowance account) for impairment or uncollectability.

Financial assets and financial liabilities that have no stated interest rate (and do not constitute a financing transaction) and are classified as payable or
receivable within one year are initially measured at an undiscounted amount in accordance with paragraph 11.14(a). Therefore, (c) above does not apply to
them. [FRS 102.11.15]

The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or a group of financial assets or
financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly
discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the
carrying amount of the financial asset or financial liability. The effective interest rate is determined on the basis of the carrying amount of the financial asset
or liability at initial recognition. Under the effective interest method:

(a)the amortised cost of a financial asset (liability) is the present value of future cash receipts (payments) discounted at the effective interest rate; and

(b)the interest expense (income) in a period equals the carrying amount of the financial liability (asset) at the beginning of a period multiplied by the
effective interest rate for the period. [FRS 102.11.16]

Because transaction costs are taken into account when determining the initial net carrying amount, their recognition in profit or loss is effectively spread
over the life of the instrument (unless a shorter period is more appropriate) and included within interest income/expense.

Example 9.2.1

Example of determining amortised cost for a five-year loan using the effective interest method
[FRS 102.11.20, Example]

On 1 January 20X0, an entity acquires a bond for Currency Units (CU) 900, incurring transaction costs of CU50. Interest of CU40 is receivable annually, in
arrears, over the next five years (31 December 20X0 to 31 December 20X4). The bond has a mandatory redemption of CU1,100 on 31 December 20X4.

Carrying amount Interest Carrying

at beginning of income at Cash amount at end
Year period 6.9583%* inflow of period

CU CU CU CU

20X0 950.00 66.11 (40.00) 976.11

20X1 976.11 67.92 (40.00) 1,004.03

20X2 1,004.03 69.86 (40.00) 1,033.89

20X3 1,033.89 71.94 (40.00) 1,065.83

20X4 1,065.83 74.16 (40.00) 1,100.00

(1,100.00) 0

* The effective interest rate of 6.9583 per cent is the rate that discounts the expected cash flows on the bond to the initial carrying
amount:
40/(1.069583)1 + 40/(1.069583)2 + 40/(1.069583)3 + 40/(1.069583)4 + 1,140/(1.069583)5 = 950

The effective interest rate is determined based on the initial carrying amount of the financial asset or liability. Therefore, the effective interest rate applied
to any financial instrument is not recalculated to reflect fair value changes in the carrying amount of the instrument.
The statement in FRS 102.11.16(b) about the amount of interest expense (income) in the period would be true only when there are no changes to the
amortised cost amount during the period other than the accrual of interest (e.g. no cash settlements of interest or principal, no impairment etc.). Changes
in the carrying amount of an amortised cost item inherently impact the recognition of interest because interest is calculated over time by applying the
effective interest rate to the carrying amount.

Under old UK GAAP excluding FRS 26 the calculation of the carrying amount and the allocation of the finance costs using a constant rate of return on the
carrying amount were similar to the FRS 102 requirements.

9.2.2 Cash flows

When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (e.g.
prepayment, call and similar options) and known credit losses that have been incurred, but it shall not consider possible future credit losses not yet
incurred. [FRS 102.11.17]

When calculating the effective interest rate, the estimated cash flows arising from the asset or liability (or, where relevant, the group of assets or liabilities)
should be used. FRS 102 explicitly states that all contractual terms of the instrument (for example prepayment, call and similar options) should be
considered, but that future credit losses should not be taken into account. This last point is consistent with the fact that the impairment model adopted in
the FRS 102 requires impairment losses to be recognised as they are incurred, rather than when they are expected (see 9.3 below).

In contrast, credit losses that have already been incurred on an instrument by the time it is acquired by the reporting entity should be taken into account
when calculating the effective interest rate. This might be the case where a financial asset is acquired at a deep discount because the value of credit losses
that have occurred are reflected in the transaction price.

The existence of certain prepayment, call and put options can mean that a debt instrument is not eligible for amortised cost measurement
(see 6.1.7 and 6.1.8). Where an instrument with such features is measured at amortised cost, the likelihood and timing of exercise of these options is
considered in estimating the expected cash flows.

9.2.3 Fees and amortisation period

When calculating the effective interest rate, an entity shall amortise any related fees, finance charges paid or received (such as ‘points’), transaction costs
and other premiums or discounts over the expected life of the instrument, except as follows. The entity shall use a shorter period if that is the period to
which the fees, finance charges paid or received, transaction costs, premiums or discounts relate. This will be the case when the variable to which the fees,
finance charges paid or received, transaction costs, premiums or discounts relate is repriced to market rates before the expected maturity of the
instrument. In such a case, the appropriate amortisation period is the period to the next such repricing date. [FRS 102.11.18]
For example, if a fee is received as compensation for a discounted interest rate over an initial period which ends with a repricing to market interest rates,
then that fee should be amortised over that initial period, rather than the expected life of the instrument. However, where the fee is not compensation for
a discounted interest rate, e.g. the floating rate resets to LIBOR plus a fixed margin every six months, the fee should be amortised over the expected life of
the instrument.

9.2.4 Changes in cash flows

9.2.4.1 Introduction

For variable rate financial assets and variable rate financial liabilities, periodic re-estimation of cash flows to reflect changes in market rates of interest alters
the effective interest rate. If a variable rate financial asset or variable rate financial liability is recognised initially at an amount equal to the principal
receivable or payable at maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or
liability. [FRS 102.11.19]

If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability (or group of
financial instruments) to reflect actual and revised estimated cash flows. The entity shall recalculate the carrying amount by computing the present value of
estimated future cash flows at the financial instrument’s original effective interest rate. The entity shall recognise the adjustment as income or expense in
profit or loss at the date of the revision. [FRS 102.11.20]

If the initial estimate of cash flows is revised for any reason other than for changes in market rates of interest for variable rate financial assets (e.g. a change
in prepayment expectations), the carrying amount is updated to reflect the revised estimated cash flows discounted at the instrument’s original effective
interest rate. The required adjustment is recognised in profit or loss.

For floating rate instruments, when cash flows are re-estimated to reflect changes in market rates of interest, the effective interest rate is updated. The
varying interest receipts/payments are a contractual term of a floating rate instrument. In this situation, it would be inappropriate to determine at
inception a single rate to discount estimated future cash flows. Instead, the Standard requires an entity to reflect changes in the interest rate in profit or
loss as such changes occur.

9.2.4.2 Changes due to changes in an inflation index

It is debatable whether changes in cash flows due to changes in an inflation index for an inflation linked instrument would be considered to reflect changes
in market rates of interest in a variable rate instrument. In the absence of any further guidance the application of either FRS 102.11.19 or 20 can be
supported. Applying FRS 102.11.19 will result in less volatility in profit or loss when compared to applying FRS 102.11.20.
If an entity chooses to apply FRS 102.11.19, there is still more than one possible approach. The simplest of these is for profit or loss to reflect only the
accrued inflation for the period up to the reporting date (i.e. the effective interest rate is not determined by looking forward to expectations of future
inflation).

An entity should choose an approach as an accounting policy and apply it consistently to inflation-linked instruments.

9.2.4.3 Changes due to the modification of contractual terms

When the terms of a debt instrument are renegotiated and modified it is necessary to consider whether the original debt instrument should be
derecognised and a new instrument with modified terms recognised (see 11.2). When the original instrument continues to be recognised but with modified
terms, the change in terms is treated in the same way as a change in expected cash flows, i.e. the revised (modified) cash flows are discounted by the
original effective interest rate. Any third party costs or fees incurred in modifying the terms are not cash flows of the debt instrument and hence would be
recognised in profit or loss as they are incurred.

Example 9.2.4.3

Example of calculating amortised cost: financial asset

Entity A purchases a debt instrument with five years remaining to maturity for its fair value of £1,000 (including transaction costs). The instrument has a
principal amount of £1,250 and carries fixed interest of 4.7 per cent that is paid annually (£1,250 × 4.7% = £59 per year).

It can be shown that in order to allocate interest receipts and the initial discount over the term of the debt instrument at a constant rate on the carrying
amount, they must be accrued at the rate of 10 per cent annually. The table below provides information about the amortised cost, interest income and cash
flows of the debt instrument in each reporting period.

(a) Amortised (b = a x (d = a + b – c)
cost at the 10%) (c) Amortised
beginning of Interest Cash cost at the end
Year the year income flows of the year

£ £ £ £

20X0 1,000 100 59 1,041

 (a) Amortised (b = a x (d = a + b – c)
cost at the 10%) (c) Amortised
beginning of Interest Cash cost at the end
Year the year income flows of the year

£ £ £ £

20X1 1,041 104 59 1,086

20X2 1,086 109 59 1,136

20X3 1,136 113 59 1,190

20X4 1,190 119 1,250 + 59 –

On the first day of 20X2 the issuer and the entity renegotiate the terms of the instrument. The issuer now will repay the debt one year later at the end of
20X5 paying a higher interest at 6 per cent. The entity incurred £10 of legal costs associated with the renegotiation and modification of the contract. In
accordance with FRS 102.11.20, the opening balance of the debt instrument in 20X2 is adjusted. The adjusted amount is calculated by discounting the
amount the entity expects to receive in 20X2 and subsequent years using the original effective interest rate (10 per cent). This results in the new opening
balance in 20X2 of £1,093. The adjustment of £7 (£1,093 – £1,086) is recorded in profit or loss in 20X2. The debt modification costs of £10 are also recorded
in profit or loss. The table below provides information about the amortised cost, interest income and cash flows as they would be adjusted taking into
account the change in estimate.
 (a) Amortised (b = a x (d = a + b – c)
cost at the 10%) (c) Amortised
beginning of Interest Cash cost at the end
Year the year income flows of the year

£ £ £ £

20X0 1,000 100 59 1,041

20X1 1,041 104 59 1,086

20X2 1,086 + 7 109 75 1,127

20X3 1,127 112 75 1,164

20X4 1,164 116 75 1,205

20X5 1,205 120 1,325 –

Under IFRSs, if the modification of a financial liability is not accounted for as an extinguishment, IAS 39:AG62 and IFRS 9:5.4.3 require that any costs and
fees incurred should adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability. This differs to the
treatment under Section 11, which requires such fees and costs to be taken to profit or loss.