How do you amortize using effective interest method?

Question

As per IFRS 9 (IAS 39) some financial assets are required to be measured at amortized cost using effective interest method. Can anyone tell me what this in fact is & how it is calculated?

Comments

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Answer 1

Before moving into effective interest method (also called "present value amortization"), it is good to know what "effective interest rate" means.

Effective interest rate is the interest rate that can be applied on the carrying amount of a financial asset to create a constant yield up to the maturity date.

For example, let's assume a bond which costs $100,000 now with a maturity value $121,000 in two years time. the effective interest rate of this bond's yeild would be 10%. This would be found as follows:
$100,000 x (1 + 0.1) = $110,000
$110,000 x (1 + 0.1) = $121,000

This means, if you use a discount rate of 10%, the NPV of a cash flow of $121,000 due in 2 years' time is equal to the initial cost of $100,000.

However, in some complicated cases an exact algebraic solution is not easy to find, and various approximation methods can be applied. Practically, most people use MS Excel IRR funtion (internal rate of return) to calculate the effective interest rate (you can find many example calculations on the internet)

Then, the carrying amount of the bond x effective interest rate = amortization