Effective interest Rate

Effective interest rate – definition

The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate. transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument.

When applying the effective interest method, an entity generally amortises any fees, points paid or received, transaction costs and other premiums or discounts that are included in the calculation of the effective interest rate over the expected life of the financial instrument.

However, a shorter period is used if this is the period to which the fees, points paid or received, transaction costs, premiums or discounts relate. This will be the case when the variable to which the fees, points paid or received, transaction costs, premiums or discounts relate is repriced to market rates before the expected maturity of the financial instrument. In such a case, the appropriate amortisation period is the period to the next such repricing date.

Floating rate instruments

For example, if a premium or discount on a floating-rate financial instrument reflects the interest that has accrued on that financial instrument since the interest was last paid, or changes in the market rates since the floating interest rate was reset to the market rates, it will be amortised to the next date when the floating interest is reset to market rates. This is because the premium or discount relates to the period to the next interest reset date because, at that date, the variable to which the premium or discount relates (i.e. interest rates) is reset to the market rates. If, however, the premium or discount results from a change in the credit spread over the floating rate specified in the financial instrument, or other variables that are not reset to the market rates, it is amortised over the expected life of the financial instrument.

For floating-rate financial assets and floating-rate financial liabilities, periodic re-estimation of cash flows to reflect the movements in the market rates of interest alters the effective interest rate. If a floating-rate financial asset or a floating-rate financial liability is recognised initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability.

Transaction costs

Example:

X Ltd lends to Mr A at Mibor + 2% reset quarterly. The tenor of the loan is 5 years. Current Mibor is 5%. The applicable rate for computing EIR will be 7%. In computing EIR, there shall be no estimate of what Mibor will be at each quarter over the life of the loan.

When Mibor changes on the next reset date to 6%, the new EIR will be 8%. Thus EIR will change with every reset date in the case of a floating loan.

The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. The Standard gives an indicative list of what constitutes integral part and what does not constitute integral part.

There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

However, in those cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument, the entity shall use the contractual cash flows over the full contractual term of the financial instrument.

This means that in the case of a fixed interest loans, the cash flows can be reliably estimated. In the case of variable loan, since it is not possible to estimate macro-economic variable, the second part of the earlier paragraph will kick in which means that the contractual cash flow prevailing today will apply.

Fees in connection with financial instruments

For the calculation of effective interest rate, an entity should identify fees that are an integral part of the effective interest rate. There are certain fees, which are an integral part of computing EIR and certain fees that are explicitly not part of EIR.

Fees that are an integral part of EIR

The fees that are an integral part of the effective interest rate of a financial instrument are treated as an adjustment to the effective rate, unless the financial instrument is measure at fair value through profit or loss.

To determine whether these are integral part of the effective interest rate of a financial instrument, the description of such fees may not be indicative of the nature and substance of the services provided. Such fees forming part of the effective interest rate include the following:

  1. Origination fees received by an entity relating to the creation or acquisition of financial asset, e.g., compensation for activities such as evaluating the borrowers financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating the terms of the instrument, preparing and processing documents and closing the transaction.
  2. Commitment fees received by the entity. These fees are regarded as compensation for an on-going involvement with the acquisition of a financial instrument. However, whenever commitment expires without a loan being disbursed, the fee is recognised as revenue on expiry.
  3. Originating fees paid on issuing financial liabilities that are measured at amortised cost.

Fees that are not integral part

Fees that are not integral part of the effective interest rate of financial instrument are accounted for in accordance with Ind AS 115. This includes:

  1. Fees charged for servicing a loan.
  2. Commitment fees to originate a loan where it is unlikely that the specific lending arrangement will be entered into.
  3. Loan syndication fees received by an entity that arranges a loan and retains no part of the loan package for itself.

While applying the effective interest rate method, the fees that are considered as an integral part of the effective rate of interest is amortised over the expected life of the financial instrument. A shorter period is used if this is the period to which such fees relate.

Commitment fees received

Loan commitment existing on the reporting date is a derivative instrument and can be designated as ‘measured at FVTPL’.

For example a commitment to give a loan to Mr X at 10% is a written call option. This option can be valued using any of the derivative valuation models would be expensed. The commitment fee will be treated as the option premium and recognized as income.

Where the loan commitment is not designated as ‘measured at FVTPL’:

  1. The commitment fee received will be kept as a liability until the loan is given out
  2. When the loan is given out, the commitment fee will be considered in considered in calculating EIR

Where the loan is not availed and commitment expires, the commitment fee will be taken to income

Origination fees paid

When the bank borrows, the financial liability is measured at amortised cost.

  • The origination fees paid will be considered in computing EIR.

The following points merit attention

Description of fees for financial services is not indicative of the nature and substance of the services provided. Fees that are an integral part of the effective interest rate of a financial instrument are treated as an adjustment to the effective interest rate.

Where the financial instrument is measured at fair value, with the change in fair value being recognised in profit or loss, the fees are recognised as revenue or expense when the instrument is initially recognised.

Transaction costs

Transaction costs include:

  • Fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers.
  • Levies by regulatory agencies and security exchanges, and transfer taxes and duties.

Transaction costs exclude:

  • Debt premiums or discounts, financing costs, internal administrative costs, and holding costs

The EIR is calculated at initial recognition of a financial asset or a financial liability. This is the internal rate of return [IRR] of the cash flow structure associated with the asset or the liability as the case may be. Based on the EIR, the present value of cash flows is equal to the gross carrying amount of the financial asset or the amortized cost of the financial liability.

At initial recognition, the gross carrying amount of a financial asset, or the amortized cost of a financial liability, is generally equal to the fair value of the instrument, adjusted for transaction costs. In other words, the relevant transaction costs are considered as cash flows in arriving at EIR.

The estimate of expected cash flows considers all contractual terms (e.g. prepayment, call and similar options) but does not consider expected credit losses i.e. the contractual cash flows are not reduced by expected credit losses. The term ‘estimate’ in our view means the cash flows computed based on known existing economic variables as on the date of inception of the financial instrument.

EIR for floating rate financial instrument

Floating-rate assets

For floating-rate financial assets and floating-rate financial liabilities, the EIR is the prevailing floating rate. As the floating rate undergoes changes, the EIR will also change.

The rule relating to no-change-in-EIR applies only to fixed rate instruments.

Where a floating rate financial instrument is recognised initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments has no significant effect on the carrying amount of the financial instruments.

An entity that, in a reporting period, calculates interest revenue by applying the effective interest method to the amortised cost of a financial asset shall, in subsequent reporting periods, calculate the interest revenue by applying the effective interest rate to the gross carrying amount if the credit risk on the financial instrument improves so that the financial asset is no longer credit-impaired and the improvement can be related objectively to an event occurring after an improvement in the borrower’s credit rating.

Calculation of effective interest rate: Example 1

On 1st January 2019, purchased 10,000 11% bonds issued by Zebra Limited @ Rs 112 per bond maturing on 31st December 2026. Calculate the effective interest rate assuming that the interest rate is payable annually on 31 December every year.

Solution to Example 1

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Calculation of effective interest rate: Example 2

On 1st January 2019, purchased 10,000 4% bonds issued by OMG Limited @ Rs 78 per bond maturing on 31st December 2025. Calculate the effective interest rate assuming that the interest rate is payable annually on 31 December every year.

Solution to Example 2

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Amortization of transaction costs

In the case of fixed rate instruments, the transaction costs will be adjusted against the cash flows and the EIR will be arrived.

Example 1:

Loan Rs. 1,00,000. Transaction costs Rs. 2,000. Repayment 11 EMIs of Rs. 10,000 each and starts from the end of the first month of disbursement of the loan.

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The EIR is computed based on the cash inflows and outflows. The transaction costs are also amortized meaning it is treated as part of the interest income over the life of the financial asset as shown below:

Any fees, points paid or received, transaction costs and other premiums or discounts included in the calculation of the effective interest rate are amortized over the expected life of the financial instrument.

Transaction costs in the case of floating rate financial instruments may be (a) costs that need to be amortized before the life of the assets. Example: full amortization before the next re-pricing date; (b) costs that have to be amortized over the life of the asset.

In the first situation (called shorter period), the amortisation happens over the shorter period namely before the next re-set date. In the second situation it is amortised over the life of the instrument.

Example 2:

The terms of an advance are as under: Loan Rs 96,000. Tenor: 2 years. Repayment of principal: Rs 4,000 pm Interest rate: 6-month MIBOR +2%. Bullet payments at the end of each half year amounting to Rs. 5,000 will be made. Upfront processing fee Rs. 2,000.

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If a premium or discount on a floating-rate financial instrument reflects the interest that has accrued on that financial instrument since the interest was last paid, or changes in the market rates since the floating interest rate was reset to the market rates, it will be amortized to the next date when the floating interest is reset to market rates. This is because the premium or discount relates to the period to the next interest reset date because, at that date, the variable to which the premium or discount relates (i.e., interest rates) is reset to the market rates.

If the premium or discount results from a change in the credit spread over the floating rate specified in the financial instrument, or other variables that are not reset to the market rates, it is amortized over the expected life of the financial instrument.

Some experts have the opinion that for floating rate instruments, it will be appropriate to apply a simplistic method of accounting – for example, by amortising transaction costs on a straight-line basis over the life of the instrument combined with a simple time apportionment approach to floating rate coupons. As per their reasoning this guidance was not included in IFRS 15 or a consequential amendment to IFRS 9 as a result of the issuance of IFRS 15. They believe this was an oversight on part of the IASB and assume that this practice should not change.

However, we stand by the view that transaction costs should be amortised on the basis of the carrying value of the principal outstanding for floating rate instruments.

In the case of floating rate instruments, the transaction costs will be amortized separately based on the ratio of the principal amount outstanding in respect of the loan as computed at every reset date.

Effective interest rate for POCI Assets

For Purchased Or Credit Impaired (POCI) financial assets, an entity should apply the credit adjusted effective interest rate to the amortised cost of the financial asset from initial recognition. Credit adjusted effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortised cost of a financial asset that is a POCI financial asset.

When calculating the credit-adjusted effective interest rate, an entity should estimate the expected cash flows by considering all contractual terms of the financial asset (for example, prepayment, extension, call and similar options) and expected credit losses.

The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

However, in those rare cases when it is not possible to reliably estimate the cash flows or the remaining life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Initial expected credit losses

An entity is required to include the initial expected credit losses in the estimated cash flows when calculating the credit-adjusted effective interest rate for financial assets that are considered to be POCI at initial recognition. However, this does not mean that a credit-adjusted effective interest rate should be applied solely because the financial asset has high credit risk at initial recognition.

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