Effective Interest Rate
Effective Interest Rate (EIR) is a new concept to the existing Indian GAAP.
TheEffective Interest Rate (EIR) method is a method of calculating the amortized cost of a financial asset or a financial liability and of allocating the interest income or interest expense over the relevant period.
TheEffective Interest Rate (EIR)use in the allocation process is the rate that exactly discounts estimated future cash flows (receipts or payments) to the net carrying amount of the financial instrument through the expected life of this instrument.
EIR calculation is not the same as for Yield to Maturity (YTM). YTM is nothing but the Internal Rate of Return (IRR) of the bond. But Effective Interest Rate (EIR) may also include some non-interest components such as loan origination charges, processing fees as part of the effective rate.
Under IFRS income from Loans and receivables has to be recognized through application of effective interest rate.
An illustration given below gives better clarity for calculation of Effective Interest Rate (EIR).
|Nominal value (payable in 5 years’ time)||INR 1,250|
|Loan origination fee (inflow)||INR 40|
|Transaction costs (directly related to loan origination, outflow)||INR (90)|
|Net transaction costs (40-90)||INR (50)|
|Fair value (net of transaction costs and fees) (1250+50)||INR 1,300|
Calculation of INTERNAL RATE OF RETURN based on above data:
|Year 1 (1250*4.7%)||59|
|Year 2 (1250*4.7%)||59|
|Year 3 (1250*4.7%)||59|
|Year 4 (1250*4.7%)||59|
|Year 5 1250 + (1250*4.7%)||1309|
Thus IRR will work out to 3.83%
Thus companies has to maintain Coupon rate as well as EIR which will practically for each transaction will be a major task and will add significantly load on IT systems.
Author: CA Shalini Tibe, IFRS Consultant