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CFM16025 - Accounting for financial instruments: IAS 32 and IAS 39: meaning of fair value, amortised cost and effective interest rate

Key definitions and terms: fair value, amortised cost and effective interest method.

IAS 39 requires many financial instruments to be measured in the accounts at fair value. It requires others to be measured at amortised cost. IAS 39 divides financial instruments into various categories ( CFM16055). These categories determine the method of measurement used.

Fair value

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Amortised cost

The amortised cost of a financial asset or financial liability is

  • the amount at which the asset or liability is measured at initial recognition (usually "cost")
  • minus any repayments of principal,
  • minus any reduction for impairment or uncollectibility, and
  • plus or minus the cumulative amortisation of the difference between that initial amount and the maturity amount.

You work out the amortisation using the effective interest method.

Effective interest method

This is a method of calculating the amortised cost of a financial asset or financial liability, and of allocating the interest income or interest expense over the relevant period. The effective interest rate in a financial instrument is the rate that exactly discounts the cash flows associated with the instrument (either through to maturity or to the next re-pricing date) to the net carrying amount at initial recognition, i.e. a constant rate on the carrying amount. The effective interest rate is sometimes termed the level yield to maturity (or the next re- pricing date), and is the internal rate of return of the financial asset or liability for that period.

There is more about computing the effective interest rate, with an example, at CFM16025a.

CFM16025b gives an example of measuring a financial asset at fair value, and at amortised cost.