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Financial In struments: Recognition and Measurement (l AS 39)
255
income or interest expense should be reported in each period for a financial asset or financial li–
ability.
6.2.2.7 The effective interest rate method allocates the contractual (or, when an asset or liability
is prepayable, the estimated) future cash payments or receipt s through the expected life of the fi–
nancial instrument or, when appropriate, a shorter period, in order to achieve a
cons tant
effective
interest rate (yield) in each period over the life of the financial instrument.
6.2.2 .8 The
effective interest ra te
is the internal rate of return of the cash flows of the asset or
liability, including the initial amount paid or received, interest payments, and principal repayments.
Practical Insight
The effective interest rate can be computed using a calculator or spreadsheet program. In
mathemat ical terms, the effec tive interest is found by setting up this equation and solving for
the interes t rate
(y)
that equates ( I) the initial carryi ng amount of the asse t or liability
(PV)
with (2) the present value of the estimated future interest and principal cash flows
(CF)
in
each period (i).
PV=± CF"
1=1
(I
+
y )
In some cases, the effective interest rate will equal the stated interest rate of the asse t or liabil–
ity. Thi s is often the case for loans and long-term note receivables or payables where the ini–
tial proceeds equals the principal and the entity was party to the contrac tual terms at its incep–
tion . For such assets, amortized cost equals cost and will be the same in each period. In other
cases, the effective interest rate differs from the stated interest rate. Th is is the case when a
debt security is purchased or issued at a premium (higher price) or discount (lowe r price) to
the stated principal (par) amount. In those cases , it is usually necessary to compute the effec–
tive interest rate and prepare an amortization schedule in order to determine amorti zed cost in
each period.
Example
This amortization schedule example illustrates how the effec tive interest method allocates the esti–
mated future cash payments or receipts in order
to
achieve a constant effective interest rate (yield)
in each period over the life ofa fi nancial instrument.
Assume that a debt security has a stated principal amount of $100,000, which will be repaid by the
issuer at maturity in fi ve years, and a stated coupon interest rate of6% per year payable annually at
the end of each year until maturity (i.e., $6,000 per year). Entity A purchases the debt security in the
market on January
I ,
20X1, fo r $93,400 (including transaction costs of $100), that is, at a discount
of $6,600
to
its principal (par) amount of $100,000. Entity A classifies the debt security as held to
maturity and makes this jou rnal entry:
DrHeld-to-maturity investments
93.400
Cr Cash
93.400
Based on the cash flows of the debt security (i.e., an initial outflow of $93,400, five annual interest
cash inflows of $6,000, and one principal cash inflow at maturity of $100,000), it can be shown that
the effective interest rate (internal rate of return) of the investment in the debt security is approxi–
mately
7.64%.
This
is
the only discount rate that will give a present value of the fu ture cash fl ows
that equals the purchase price.
Based on the effective interest rate of
7.64%,
the amortized cost and reported interest income in
each year over the life of the fina ncial asset can be computed as indicated in this amortization
schedule: