Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

EFFECTIVE INTEREST RATE

The effective interest rate is the internal rate of return (IRR) or the level yield to maturity. It is the rate that exactly discounts the estimated future cash flows or receipts through the expected life of the instrument, or where appropriate, a shorter period, to the net carrying amount at initial recognition

An entity should estimate cash flows considering all contractual terms of the financial instrument including prepayment, call and similar options, when calculating the effective interest rate. The entity should not consider the future credit losses while calculating the effective interest rate. 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 following aspects should be considered while arriving at the effective interest rate:

• For financial assets that are acquired at a deep discount, the price reflects incurred credit losses. Since this represents incurred credit losses these should be included in the estimated cash flows when computing the effective interest rate.
• The entity should amortize any fees, paid or received, transaction costs and other premiums or discounts included in the calculation of the effective interest rate over the expected life of the instrument.
• A shorter period is used if this is the period to which the fees, points paid or received, transaction costs, premiums ...