What is the concept of effective interest method?

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.

Ind AS Accounting Standards

Effective Rate of Interest – EIR

What is SPPI test?

Are RBI circulars relevant for ECL computation as per Ind AS 109?

What is a Financial instrument?

Is there a choice to designate as FVTPL?

What are treasury shares and how are these presented

Contract to deal in non-financial item

Can a corporate entity still follow settlement date accounting?

What does Interest represent?

Gains and losses on assets measured at FVOCI

Separately accounting for an embedded derivative

Derecognition of a financial asset

Foreign currency risk in a firm commitment as a fair value hedge

Treatment of transaction costs

Derecognise financial assets/financial liabilities retrospectively

Modification of contractual cash flows

Own use exemption as per the Accounting Standard

Difference between amortised cost & held-to-maturity

Accounting treatment for FVOCI Instruments

What is a hybrid contract?

First-time adoption while classifying a financial instrument

SPPI test & business model objective test

Current standards for financial instruments as per AS?

Effective interest Rate

Contract is settled through the entity’s own equity instrument

Financial asset categorised as FVOCI

What is an embedded derivative?

Impairment model for different categories of financial assets

Ind ASs relating to financial instruments

FVOCI (equity instruments) and FVOCI (debt instruments)

Classification of derivative instruments

Contract meant for own use

Reclassification of a financial asset

Debt instrument measured at FVOCI

Change in contractual cash flows

Loss allowance as per Ind AS 109

Ind AS for financial instruments replica of IFRS?

Contractual cash flows & effective interest rate

Long-term financial liability classified as FVTPL

Credit adjusted effective interest rate

Effective rate of interest during the first-time adoption

Consequence of not de-recognising an asset after the sale

Designation of contracts deal a non-financial item on first time adoption

Recognition of financial instruments on first-time adoption

Gains and losses on a financial instrument

Gains and losses from liabilities designated as FVTPL

Measurement categories for financial assets

Difference between time value of money and modified time value of money