# Financial liabilities at amortized cost

Financial liabilities classified as “financial liabilities at amortized cost” are initially recognized at their fair values. Any transaction costs associated with the financial liabilities are deducted from their fair values. Formula for initial recognition of amortized cost liabilities is as follows:

Initial recognition of AC financial liability = 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.

Let’s see how financial liabilities at amortized cost are measured subsequently.

## Subsequent measurement

After initial recognition, financial liabilities 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 liabilities. Under this method, financial liabilities are carried in the books of account using the following formula:

Subsequent measurement of AC financial liability = Opening balance + interest expense – interest paid

Interest expense (finance cost) 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 liability at amortized cost, effective interest rate will be the rate that discounts the future cash flows of that financial liability to its initial recognition value i.e. fair value minus transaction costs, if any. Effective interest can be calculated using the “internal rate of return (IRR) formula”.

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

• Opening balance
• Interest expense (at effective interest rate)
• Interest paid (at nominal interest rate)
• Closing balance

Interest expense calculated by the amortized cost table is recorded in the statement of profit or loss, whereas, closing balance of financial liability 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 liabilities at amortized cost.

### Example – Financial liabilities at amortized cost

On 1 January 20×1, ABC Company issued bonds having face value of \$200,000 carrying interest rate of 6% per annum. Interest is payable in arrears. Commission of \$4,000 was paid to the dealer who arranged this transaction. 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 liability be accounted for by ABC Company?