What is the concept of effective interest method?

Explain the concept of effective interest method?

Effective interest method is a new concept that is introduced through the Ind AS standards. Effective interest rate is relevant not merely for financial instruments, but as a concept running through the entire gamut of the Accounting Standards as per Ind AS. The effective interest rate is the rate that exactly discounts the 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. The expected cash flows should be arrived at by considering all the contractual terms of the financial instrument including pre-payment, extension or call or put option, etc. Wherever transaction costs are relevant to be included, the same should be considered for computing the effective interest rate.

Interest revenue shall be calculated by using the effective interest method. This is calculated by applying the effective interest rate to the gross carrying amount of a financial asset.

For the calculation of effective interest rate, an entity should identify fees that are an integral part of the effective interest rate. 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 measured at fair value through profit or loss. Fees forming part of the effective interest rate include origination fees received by an entity relating to the creation or acquisition of financial asset, eg, 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. Also included are commitment fees received by the entity and originating fees paid on issuing financial liabilities that are measured at amortised cost.

Fees that are not integral part of the effective interest rate of financial instrument are fees charged for servicing a loan, commitment fees to originate a loan where it is unlikely that the specific lending arrangement will be entered into and loan syndication fees received by an entity that arranges a loan and retains no part of the loan package for itself. Such fees are to be treated as per the standard on revenue recognition.

It should be noted that 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. Effective interest rate, the term used in Ind AS is the same as internal rate of return, which is commonly used in Microsoft Excel. It is also the same as ‘yield to maturity’, the term used in bond markets. Effective interest rate is computed on instrument by instrument basis on initial recognition and once computed, the effective interest rate does not undergo any change throughout the life of the asset except for a hedged item on discontinuation of hedge accounting.