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).

Given Data:

Calculation of INTERNAL RATE OF RETURN based on above data:

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

Related posts:

1. Interest rate Derivatives: Cap
2. Interest Rate Floor
3. Phase 2 of IFRS 9: Exposure Draft on Amortised cost and Impairment

IFRS is a principle based model as compared to rule based I GAAP. IFRS requires extensive use of fair valuations for measurement of assets and liabilities. The objective of IFRS is to set the Balance Sheet right, and hence a significant volatility may come in Profit & Loss statement.

There are three principles laid down in IFRS i.e. Substance over form in reality, use of Fair Value and recognizing time value of money.

Changes in IFRS are pervasive and not limited to accounts department. Profit planning and budgeting need to be tuned to incorporate the expected increase in income volatility, arising out of fair valuation system. Staff would need training not only in IFRS accounting but also the changes in the products and processes entailed by the conversion

Key differences in IFRS Vis a Vis INDIAN GAAP

• Concept of group – Companies Act treats Indian companies as separate legal entity whereas IFRS promote a group concept

• Fair Valuation – IFRS based on Fair value concept and not historical cost

• Form and Substance of financial statements

• Correction of past errors – Under IFRS these are incorporated in the accounts of the years it pertains to, even if audited and adopted by shareholders whereas under Indian GAAP these are treated as adjustment in the current year

• Depreciation on revalued assets needs to be routed through income statement under IFRS – Companies Act disallows such a treatment

• Companies Act defines assets by classes which can be depreciated at given rates, whereas as IFRS promotes the concept of components of fixed assets based on their usefulness

• Preference shares are classified as debt instrument and not equity effecting profitability and Capital adequacy ratio

• No concept of proposed dividend – Declaration of dividend only when approved by shareholders

India being an important emerging economy in the world is yet to adopt the IFRSs. Internationally, in so far as cross-border investments are concerned, a non-IFRS compliant country is perceived as an additional risk factor. Within India also, in recent times, the issue of convergence with IFRSs has been raised time and again at various forums.

One of the risks I feel that IFRS entails is allowing companies to capture unrealized gain in P/L resulting in extra onus on the management to exercise better financial discipline. Because of this companies may end up declaring dividend out of unrealized profits.

Author: CA Shalini Tibe, IFRS Consultant

Related posts:

1. Fair Value Accounting in IFRS
2. Comparison of IFRS and Indian Accounting Standards
3. IFRS: an improvement in accounting quality as well as corporate governance