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What Is Amortized Cost?

Amortized cost is an accounting measurement method used primarily for financial assets and financial liabilities that are held within a business model whose objective is to collect contractual cash flows rather than to sell the assets. This method falls under the broader category of accounting and financial reporting, providing a systematic way to adjust the initial cost of an asset or liability over its life. It ensures that the asset or liability is reported at an amount that reflects its true economic value over time, factoring in any initial discount or premium. The value is adjusted for scheduled principal repayments and interest recognized using the effective interest rate method. Amortized cost is particularly relevant for debt instruments like bonds and loans.

History and Origin

The concept of measuring financial instruments at amortized cost has evolved alongside international and national accounting standards. Historically, financial instruments were often carried at historical cost. However, the complexity of financial markets and the need for more relevant financial reporting led to the development of sophisticated frameworks. A significant development in this regard occurred with the International Accounting Standards Board (IASB)'s issuance of IFRS 9 Financial Instruments, which replaced IAS 39. IFRS 9 introduced a new model for the classification and measurement of financial assets, distinguishing between those measured at amortized cost, fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL). The standard, fully effective from January 1, 2018, was accelerated in response to the global financial crisis, aiming to address concerns about the timeliness of recognizing expected credit losses and the complexity of multiple impairment models.⁴

Key Takeaways

• Amortized cost is an accounting measurement method for certain financial instruments, reflecting their carrying value over time.
• It is applied to financial assets and liabilities held primarily to collect contractual cash flows.
• The effective interest method is used to amortize any premium or discount over the instrument's life.
• The carrying amount is adjusted for any impairment losses.
• It is a fundamental concept in both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP).

Formula and Calculation

The amortized cost of a financial instrument is calculated by adjusting its initial recognition amount for cumulative amortization using the effective interest method and any cumulative impairment losses.

The effective interest method involves calculating the interest expense or income by multiplying the carrying amount of the financial instrument at the beginning of the period by its effective interest rate. The difference between the cash interest paid/received and the calculated interest expense/income adjusts the carrying amount.

For a bond initially recognized at a discount:

For a bond initially recognized at a premium:

Where:

• Amortized Cost at Period Start = The carrying amount of the financial instrument at the beginning of the period.
• Effective Interest Income = Carrying amount at period start × Effective interest rate.
• Cash Received = The actual cash interest payment or receipt based on the bond's stated coupon rate and principal.

This calculation systematically adjusts the book value of the instrument on the balance sheet over its maturity, ensuring that the yield recognized over time matches the effective yield at inception.

Interpreting Amortized Cost

Interpreting amortized cost involves understanding that it represents the net amount at which a financial asset or liability is measured, reflecting the historical transaction adjusted for the passage of time and any principal repayments or premium/discount amortization. For debt instruments, the amortized cost gradually moves towards the instrument's face value as it approaches maturity. This approach provides a consistent, predictable measure that aligns with the entity's intention to hold the instrument to collect its contractual cash flows. Unlike fair value, which fluctuates with market conditions, amortized cost offers a stable carrying value that prioritizes the contractual cash flow stream. It is particularly useful for financial institutions holding a portfolio of loans, as it represents the net investment in these assets, adjusted for any expected credit losses. The consistent application of accrual accounting principles underpins the amortized cost method.

Hypothetical Example

Consider a company, "Lending Corp," that issues a $100,000 bond with a 5% coupon rate, paying interest annually. The bond has a 3-year maturity and is issued at a discount for $95,000 to yield an effective interest rate of 6.91%.

Year 1:

• Beginning amortized cost: $95,000
• Effective interest expense (6.91% of $95,000): $6,564.50
• Cash interest paid (5% of $100,000): $5,000
• Amortization of discount: $6,564.50 - $5,000 = $1,564.50
• Ending amortized cost: $95,000 + $1,564.50 = $96,564.50

Year 2:

• Beginning amortized cost: $96,564.50
• Effective interest expense (6.91% of $96,564.50): $6,674.50
• Cash interest paid: $5,000
• Amortization of discount: $6,674.50 - $5,000 = $1,674.50
• Ending amortized cost: $96,564.50 + $1,674.50 = $98,239.00

Year 3:

• Beginning amortized cost: $98,239.00
• Effective interest expense (6.91% of $98,239.00, adjusted for rounding): $6,761.00 (This amount is adjusted so the final amortized cost matches the face value)
• Cash interest paid: $5,000
• Amortization of discount: $6,761.00 - $5,000 = $1,761.00
• Ending amortized cost: $98,239.00 + $1,761.00 = $100,000.00 (Face value)

Over the three years, the discount is fully amortized, and the bond's carrying value reaches its face value at maturity. The effective interest expense is recognized on the income statement each period.

Practical Applications

Amortized cost is widely applied in financial reporting for various types of financial instruments. Its primary use is for debt instruments where the entity's business model is to hold them to collect contractual cash flows. This includes:

• Loans and Receivables: Banks typically measure their loan portfolios, including mortgages, auto loans, and corporate loans, at amortized cost, adjusted for an allowance for expected credit losses.
• Held-to-Collect Debt Securities: Investment portfolios of debt securities (e.g., government bonds, corporate bonds) that are intended to be held until maturity fall under this category.
• Lease Liabilities: Under new lease accounting standards (e.g., IFRS 16, ASC 842), lease liabilities are initially recognized at the present value of lease payments and subsequently measured at amortized cost.
• Financial Liabilities at Amortized Cost: Most corporate debt, such as bonds payable and bank loans, is measured at amortized cost.

In the U.S., the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Topic 326, which fundamentally changed how credit losses are measured for financial instruments carried at amortized cost. This "Current Expected Credit Loss" (CECL) model requires entities to measure all expected credit losses over the contractual term of their financial assets, considering historical experience, current conditions, and reasonable and supportable forecasts. ³For money market funds, the Investment Company Institute (ICI) has argued that the use of amortized cost is appropriate for money market funds that intend to hold their investments and realize the contractual cash flows.
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Limitations and Criticisms

Despite its widespread use, amortized cost has certain limitations and has faced criticism, especially when compared to fair value accounting.

• Lack of Current Value Representation: A primary criticism is that amortized cost does not reflect the current market value of financial instruments. If interest rates change significantly, the instrument's fair value can diverge substantially from its amortized cost, potentially misleading users about the true economic value of assets or liabilities. This issue is particularly pronounced for financial instruments that are actively traded or sensitive to market fluctuations.
• Delayed Recognition of Losses (Pre-CECL): Before the implementation of CECL (in U.S. GAAP) and the impairment requirements in IFRS 9, a common criticism was the "incurred loss" model's "too little, too late" problem, where credit losses were only recognized when they were probable, leading to delayed recognition during economic downturns. While CECL and IFRS 9's expected credit loss models aim to mitigate this by requiring forward-looking assessments, the fundamental measurement basis remains historical.
• Limited Usefulness for Complex Instruments: The amortized cost approach is most suitable for simple financial instruments with fixed cash flows and straightforward terms. For more complex instruments, or those with embedded derivatives or uncertain cash flows, its application can be less straightforward or even inappropriate.
• Comparability Issues: Different accounting standards or interpretations can lead to variations in the application of amortized cost, potentially affecting comparability across entities or jurisdictions.
• Impact on Financial Stability: Some academic research suggests that strict adherence to amortized cost for certain financial assets might reduce the timeliness of recognizing non-recurring write-downs compared to fair value measurement, potentially obscuring financial distress.
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Amortized Cost vs. Fair Value

The distinction between amortized cost and fair value is a fundamental aspect of financial reporting.

The primary confusion between the two arises because both are methods for valuing financial instruments. However, they serve different purposes based on the entity's business model for managing those instruments. Amortized cost emphasizes the contractual cash flows and the entity's intent to collect them, while fair value emphasizes the current market's assessment of the instrument's value.

FAQs

Q1: When is amortized cost used?

Amortized cost is used for financial assets and financial liabilities that an entity intends to hold primarily to collect their contractual cash flows. This typically applies to loans, receivables, and debt securities held to maturity, as well as most financial liabilities like bonds payable.

Q2: How does amortized cost differ from historical cost?

Historical cost is the initial cost at which an asset or liability was acquired or incurred. Amortized cost starts with the historical cost but then systematically adjusts it over time using the effective interest method to account for any premium or discount on initial recognition, as well as for scheduled principal repayments and impairment losses.

Q3: Does amortized cost account for credit losses?

Yes, under current accounting standards (like IFRS 9 and ASC 326 CECL), instruments measured at amortized cost must be assessed for expected credit losses. This means that an allowance for anticipated future credit losses is recognized, which reduces the carrying value of the asset to its estimated recoverable amount.