Amortised cost accounting is a way of measuring financial assets and liabilities in which an instrument is carried at the amount first recognised, less repayments of principal, plus or minus the gradual spreading of any difference between that amount and the amount due at maturity. For assets, the figure is also reduced by an allowance for expected losses. It is the standard treatment for most bank loans, trade receivables, deposits and issued debt.
The method contrasts with fair value accounting, in which the carrying amount follows market prices. Under amortised cost, changes in market interest rates do not affect the balance sheet or profit unless the instrument is sold or impaired. The rules are set mainly by IFRS 9, issued by the International Accounting Standards Board (IASB), with broadly similar treatment under US accounting standards.
When amortised cost applies
Under IFRS 9 a financial asset is measured at amortised cost only if it passes two tests. The business model test asks whether the asset is held in order to collect its contractual cash flows, as opposed to being held for sale or trading. The cash flow test asks whether those cash flows are solely payments of principal and interest on the amount outstanding. A plain loan or bond passes; an instrument whose return depends on a share price or a commodity does not.
Assets that pass the cash flow test but are held both to collect and to sell are measured at fair value with changes recorded in other comprehensive income. Everything else is measured at fair value through profit or loss. Most financial liabilities, including deposits, borrowings and bonds in issue, are measured at amortised cost unless they are held for trading or the entity chooses fair value.
How the calculation works
The instrument is first recognised at fair value plus or minus transaction costs that are directly linked to it, such as arrangement fees. Interest is then recognised using the effective interest rate method. The effective rate is the rate that discounts all expected cash flows over the life of the instrument back to its initial carrying amount, so fees, discounts and premiums are spread over the life as part of the yield.
The carrying amount at any date can be written as:
- Initial amount is the fair value at recognition, adjusted for transaction costs.
- Principal repaid is the total of capital repayments received or made so far.
- Cumulative amortisation is the part of any discount or premium recognised to date through the effective rate.
- Loss allowance applies to assets only.
Suppose a company buys a five-year bond with a face value of 1,000 and a 5% annual coupon for 950. The effective interest rate is about 6.19%. In the first year, interest income is 950 multiplied by 6.19%, or about 58.8. The cash coupon is 50, so the remaining 8.8 is added to the carrying amount, which becomes 958.8. The same steps are repeated each year until the carrying amount reaches 1,000 at maturity. The bookkeeping is the same as the amortisation of a bond discount; a bond bought above face value works in reverse.
Impairment and modification
Assets carried at amortised cost are subject to impairment accounting. IFRS 9 requires an allowance for expected credit loss (ECL) from the day the asset is recognised, with the size of the allowance depending on how credit risk has moved since then. This is the process described in staging under IFRS 9. For assets that are credit-impaired, interest is calculated on the carrying amount net of the allowance.
If the terms of an instrument are renegotiated, the entity has to decide whether the change is substantial. A substantial loan modification leads to the old instrument being removed and a new one recognised at fair value. A smaller change keeps the original effective rate, and the carrying amount is recalculated with the difference taken to profit or loss.
Strengths and criticism
Amortised cost gives stable, predictable figures that reflect how a lender that holds assets to maturity actually earns its return. It keeps short-term market swings out of reported profit and capital.
The criticism is that it can hide economic losses. When interest rates rise, fixed-rate bonds fall in value, but the fall does not appear in the accounts of a holder using amortised cost. The failures of several US regional banks in 2023 drew attention to large unrealised losses on securities carried this way. Standard setters respond that disclosure of fair values in the notes to the financial statements, together with the business model test, addresses the concern.