What Is Amortised Cost and How Is It Calculated?

Amortized cost is an accounting measurement method for certain financial assets and liabilities. Its function is to present the value of a financial instrument on the balance sheet by systematically adjusting its initial value over its lifespan. This adjustment process accounts for the repayment of principal and the amortization of any premium or discount that existed at the time of acquisition.

The purpose of using amortized cost is to smooth out the recognition of interest income or expense over the instrument’s life, providing a more stable representation than market-based fair value, which can fluctuate. This method provides a predictable valuation based on the instrument’s scheduled cash flows.

Initial Measurement of a Financial Instrument

A financial instrument must first be measured at its initial recognition. For most financial assets and liabilities, this initial value is their fair value, which is the transaction price—the amount of cash paid or received to acquire or issue the instrument. This initial fair value is then adjusted by any directly attributable transaction costs.

Transaction costs are incremental costs that are directly tied to the acquisition, issue, or disposal of a financial instrument. These include fees and commissions paid to agents, advisers, brokers, and dealers; levies by regulatory agencies and securities exchanges; and transfer taxes and duties.

For a financial asset, these transaction costs are added to the fair value. If a company purchases a bond for $98,000 and pays a $1,000 broker fee, the initial carrying amount of the asset is $99,000. Conversely, for a financial liability, transaction costs are deducted from the fair value. If a company issues a bond and receives $102,000 but pays $1,500 in issuance fees, the initial carrying amount of the liability is $100,500.

Costs such as debt premiums or discounts, financing costs, or internal administrative or holding costs are not included in the initial measurement as transaction costs.

The Amortised Cost Calculation Method

The calculation of amortized cost is performed using the effective interest method. This method allocates interest income or interest expense over the relevant period to achieve a constant rate of return on the carrying amount of the financial instrument. It applies the interest rate to the outstanding balance of the instrument each period, reflecting the true economic accrual of interest.

The first step is to determine the effective interest rate (EIR). The EIR is the specific rate that exactly discounts all estimated future cash payments or receipts through the expected life of the instrument back to its initial carrying amount. This calculation must incorporate all contractual terms and include all fees, transaction costs, and any premiums or discounts. Essentially, the EIR is the instrument’s internal rate of return.

Consider a company that purchases a 3-year, $100,000 face value bond for $95,026, with a stated interest rate of 5% paid annually. The effective interest rate is calculated to be 7%. In Year 1, the interest income would be $6,652 ($95,026 7%), while the cash received is $5,000 ($100,000 5%). The $1,652 difference is the amortized discount, increasing the carrying amount to $96,678. This process continues until the carrying amount equals the $100,000 face value at maturity.

For a financial liability, imagine a company issues a 3-year, $200,000 bond at a premium, receiving $205,271. The bond pays a 6% coupon, but the effective interest rate is 5%. In Year 1, the interest expense is $10,264 ($205,271 5%), while the cash paid is $12,000 ($200,000 6%). The $1,736 difference reduces the carrying amount to $203,535. This amortization of the premium continues, bringing the liability’s carrying amount down to its $200,000 face value at maturity.

Criteria for Using Amortised Cost

For a financial asset to be measured at amortized cost, it must satisfy two specific criteria. Failing either of these tests means the asset must be measured at fair value, which can introduce more volatility into financial statements.

The first condition is the “Business Model Test.” To qualify for amortized cost, the asset must be held within a business model whose objective is to “hold to collect” the contractual cash flows, rather than actively trading it to realize short-term price gains.

The second condition is the “Cash Flow Characteristics Test,” often referred to as the SPPI test. The contractual terms must give rise to cash flows on specified dates that are “solely payments of principal and interest” (SPPI) on the principal amount outstanding. Principal is the fair value of the asset at initial recognition, while interest consists of consideration for the time value of money, credit risk, and a profit margin.

Instruments that typically meet both criteria include standard corporate bonds held to maturity, trade receivables, and simple loans. Conversely, instruments that would fail the SPPI test include convertible bonds or investments in equity shares. For many financial liabilities, such as loans payable or bonds issued, amortized cost is the default measurement unless they are specifically designated to be measured at fair value.

Recognizing Impairment Losses

Even when an asset is measured at amortized cost, its value must be reassessed if there is evidence that the holder may not be able to collect all the contractually owed money. This is known as impairment. Modern accounting standards require a forward-looking approach to recognizing these potential losses through an “Expected Credit Loss” (ECL) model.

The ECL model moves away from waiting for an actual default or “incurred loss” event to occur before recognizing a loss. Instead, entities must estimate and account for potential credit losses from the moment a financial asset is acquired. This model requires considering past events, current conditions, and reasonable forecasts of future economic conditions that could affect the borrower’s ability to pay.

When an expected credit loss is identified, it is recognized by creating a loss allowance, which is a contra-asset account that reduces the gross carrying amount of the financial asset on the balance sheet. The corresponding entry is a charge to an impairment loss expense in the income statement. This ensures that the asset’s net carrying amount reflects the present value of the cash flows that the entity actually expects to collect.

Under this model, a bank doesn’t wait for a borrower to miss several payments before recognizing a loss on a loan. It would estimate the probability of default over the loan’s life from day one and update that estimate each reporting period based on changes in credit risk, booking a provision for expected losses accordingly.