Financial assets at amortized cost

As explained in our chapter “classification of financial assets”, any investment in debt instrument will be classified as financial asset at amortized cost if the following conditions are met:

  • the entity’s business model is to hold the financial asset till its maturity and obtain benefits by collecting the contractual cash flows associated with the financial asset
  • the contractual cash flows arising from the financial asset are solely payments of principal and interest (SPPI).

Now, let’s study the accounting of financial assets classified as “financial assets at amortized cost”.

Initial recognition

An entity will recognize a financial asset when it becomes party to a contract of the financial instrument. Initially, a financial asset at amortized cost is recognized at its fair value. Any transaction costs incurred to acquire the financial asset are added in the cost of the financial asset. Formula for initial recognition of a financial asset at amortized cost is as follows:

Initial recognition of AC financial asset = Fair value + Transaction costs

What are transaction costs? Transaction costs are incremental costs incurred to acquire or issue a financial instrument. The word incremental means that such costs would not have been incurred if the financial instrument were not acquired or issued. Some examples of transaction costs are given below:

  • instrument issuance or registration fee
  • commission of brokers and dealers
  • taxes and levies on sale/purchase of financial instruments etc.

Subsequent measurement

After initial recognition, financial assets at amortized cost are subsequently measured using the effective interest rate method.

What is effective interest rate method? It is a method for subsequent measurement of financial assets. Under this method, financial assets are carried in the books of account using the following formula:

Subsequent measurement of AC financial asset = Opening balance + interest income – payment received

Interest income in the above formula is calculated using the effective interest rate of the instrument and is recorded in the statement of profit or loss (income statement). Effective interest rate is the rate that discounts the future cash flows of a financial instrument exactly to its initially recognized value. In case of a financial asset at amortized cost, effective interest rate will be the rate that discounts the future cash flows of that financial asset to its initial recognition value i.e. fair value plus transaction costs, if any. Effective interest rate can be calculated using the “internal rate of return (IRR) formula”.

For accounting of financial assets at amortized cost, usually a table is used which has four columns for the following four items:

  • Opening balance
  • Interest income
  • Payment received
  • Closing balance

Interest income calculated by the amortized cost table is recorded in the statement of profit or loss, whereas, closing balance of financial asset is presented in the balance sheet.

Let’s take a look at the following example to clarify our concepts related to the accounting of financial assets at amortized cost.

Example

On 1 January 20X1, XYZ Company invested $200,000 in debentures carrying interest rate of 6% per annum. Interest is receivable in arrears. Commission of $4,000 was paid to a dealer who arranged this investment. As per contractual terms, the debentures will be redeemed at a premium of $10,000 over their nominal value. Term of the debentures is four years and will be redeemed on 31 December 20×4. Effective interest rate is 6.55% per annum.

How will this financial asset be accounted for by XYZ Company, if the company’s business model is to hold such investments till their maturity?

Answer

As the company’s business model is to hold the investment till its maturity, and the contractual cash flows are solely payment of principal and interest, the investment in debentures will be classified as financial asset at amortized cost.

On 1 January 20×1, financial asset will be recognized at its fair value plus transaction costs.

Financial asset = $200,000 + $4,000 = $204,000

For subsequent accounting, we’ll make the amortized cost table as follows.