Amortized Cost Definition
Amortized cost is an accounting method in which all financial assets must be reported on a balance sheet at their amortized value which is equal to their acquisition total minus their principal repayments and any discounts or premiums minus any impairment losses and exchange differences.
A Little More on What is Amortized Costs
Amortized cost applies to debts that meet the following criteria:
- A contractual cash flow of financial assets which are on repayment plans of principals and interests that occur on scheduled dates.
- A business model of companies that own assets to collect their contractual cash flows instead of selling.
Effective interest rate method
Financial assets which meet the criteria and definition of amortized costs such as a bond, which carries a cash flow stream defined by their coupon rate. But over the bond’s term period, the interest rate can differ as the market differs. If the market rate goes up and is higher than the noted rate, the bond price in the market is lower than its overall maturity value. The only example in which the market price and the bond’s price would be the same is when the interest rate in the market and the face value rate are the same, but this is a rare occasion that this occurs.
There are a few requirements any discount or premiums arise when a financial assets carry amortized costs using an interest rate method. Under these methods the interest rates is calculated by adding in the market rate to the bonds carry rate. The difference between the income interest should be recognized as the interest income being paid. This can be used to write off any discounts and premiums so there is a zero balance at the end of the bonds term period.
Example of Amortized Costs
The following is an example that shows how the application of this interest rate method can work:
On January 1st, 2015, the company Drive. Inc invests 20,000 company bonds whose value is $100 and their coupon rate is 6% which is payable each year until it matures in 10 years. If the market rate was 6.5% Drive. Inc would then pay $1,928.112 for all the bonds. This is using the discounted bond and cash flow method using the market interest rate. PV(6.5%, 10,-120000-2000000). Drive Inc would than record the acquisition of the bond: Investments are held at an amortized cost of Company X bonds- $2,000,000.
Cash(This is the present value of the bond’s current cash flow)
Discount on the Company’s X bonds
Drive, Inc reports that the bonds were purchased at $1,928,112 on their balance sheet (this is face value minus any discounts). The discount on the Company X bonds is a subsidiary to the Company X bond assets.
The first payment on the interest is due on December 31, 2015, which will total $120,000 (This is =$2,000,000*6%). However, Drive, Inc is unable to record this $120,000 as their interest income because according to the interest method, they also need to account for the discount which was given initially on the bonds. Therefore their record of receipt should depict the following:
Cash ($2,000,000* 6%)
Discount on the Company X Bonds
Interest income reported($1,928,112*6.5%)
After the very first payment, the value of the Company X bonds recorded of Drive, Inc shall be shown as follows:
Face value of the Company X bonds:
Minus the discount on the Company X bonds on December 31, 2015 ($71,88-$5,327)
Total amortized cost of the Company X bonds on December 31, 2015
The journal notation for the second total interest payment on December 31, 2016 will be as follows:
Discount on the Company X Bonds
Interest Income total (1,933,439 * 6.5%)
References for Amortized Costs
Academic Research for Amortized Costs
• Amortized cost for operating lease assets, Jennings, R., & Marques, A. (2012). In this document we’ll take a more in depth look into the amortized costs which are associated with operating lease assets. There is a proposed accounting standard which has been issued jointly by the FASB, the Financial Accounting Standards Board, and the IASB, the International Accounting Standards Board. These require firms to recognize many other lease assets that are required to be amortized on a straight line basis. Many respondents argue that the front loading of these lease expenses result from straight line amortization, and this does not change or reflect the economics of lease assets. This study compares this straight line amortization to the present value amortization and explores the benefits and disadvantages. First it is shown by example that under much stylized conditions the present value amortization method provides more information that accurately represents the future cash flow of these lease assets, more so than the straight line amortization method. Secondly, the larger subset of firms are more likely to undergo these stylized conditions in the example above. And it is found that the investors value these firms as those the lease assets appear to be capitalized and amortized on their present value methods. Last, it is found that the financial ratio is comparable to the increasing operating leases when constructively capitalized and amortized using the straight line method. This also further increases when the present value amortization method is used. When taken together these results really don’t provide any evidence favoring the straight line method over the present value method.
• What is an Asset?, Schuetze, W. P. (2004). In Mark to Market Accounting (pp. 72-78). Routledge. Do you really know what an asset is? We will learn more in this article about what an asset is and why it’s important in regards to the financial accounting standards board and the overall health of the financial community in general. It has been encouraged to the Financial Accounting Standards Board to embrace the idea of mark to market for more profitable and marketable securities. However, contrary to the perception of some, it has not really been thoroughly promoted in the mark to market manner. An example of this is in reference to plant and equipment, copyrights, patents and commercial loans held by banks. When the staff suggest an idea to look for an identify the impairment of the carrying amount of all these assets like stocks, plant, patents, loans and bonds, it is then appropriate to take a look into the fair value of the asset and compare it to the fair value of the carrying amount. When impairment is therefore measured the fair value of the said asset would help to provide the most relevant measurement of any impairment. This approach is considered to be consistent in finding the measurements of foreclosed assets.
• Accounting conservatism, the quality of earnings, and stock returns, Penman, S. H., & Zhang, X. J. (2002). This document takes a look into what accounting conservatism really is and how the quality of the earnings and stock returns matter in this department. When a firm begins to first practice conservative accounting practices, there are changes in the amount of their investments which can also correlate a change in the quality of their earnings. This is looked at as growth in the investment which can reduce the reported earnings and also create additional and new reserves. Reducing these investment releases these reserves which which also temporarily increase earnings. If this investment change is temporary then the current earnings reported will temporarily decrease or inflate, which is not a good indicator of future earnings. This study works to provide and develop better diagnostic measures for these joint effect of investments and conservative accounting methods. They have found that these measurement foretell differences in the return on investments and future operating assets when relative to the current returns. These measurements also can forecast the stock returns which indicate that investors do not truly appreciate how conservatism changes things and raises questions about the quality of these reported earnings.
• Does convergence of accounting standards lead to the convergence of accounting practices?: A study from China, Peng, S., Tondkar, R. H., van der Laan Smith, J., & Harless, D. W. (2008). In this article we’ll look at how the convergence of accounting standards can lead to the convergence of accounting practices. This study originates out of China and provides information from an empirical study to look at whether the efforts to converge domestic accounting standards with International financial reporting standards over the course of 15 years have resulted in more favorable and successful convergence. This study evaluates the convergence firms practices from three different perspectives. (1) the level of compliance (2) the consistency which surrounds accounting choices, (3) the identification of these differences in the net incomes all under the Chinese GAAP and IFRS (the earnings gap). Using two reports from 1999 and 2002 in 79 different Chinese firms it is found that there is improvement in both compliance and consistency using these accounting methods. However, it is observed that the listed firms compliance with the IFRS is lower than their compliance with the Chinese GAAP. It is believed that the findings suggest that at least in China the convergence of accounting standards are conduit to the convergence of their accounting practices.
Loan guarantees: Costs of default and benefits to small firms, Riding, A. L., & Haines, G. (2001). Journal of business venturing, 16(6), 595-612. What are the costs of benefits and defaults in regards to small firms? We’ll discuss just those issues in this issue of journal of business venturing.
• The crisis of fair-value accounting: Making sense of the recent debate, Laux, C., & Leuz, C. (2009). Accounting, organizations and society, 34(6-7), 826-834. This article takes a look at the crisis that surrounds us with fair-value accounting methods. It helps you to understand more about the recent debate that has been happening. This recent crisis has often lead to this debate about the pros and cons that surround fair-value accounting, also referred to as FVA. This debate creates a big challenge for the FVA moving forward to set standards and looking to extend FVA into other areas. Four important issues are highlighted in this article that attempt to make more sense about this intricate debate. The first is the controversy that surrounds the what is different and new about FVA. The second is the concerns about marking to market also known as the pure FVA when there is a financial crisis. Third is the historical cost accounting, referred to as HCA, which really isn’t likely to be a remedy for the issues. While the fourth is the implementation issues about the FVA standards in their respect to litigation. We also take a look at different avenues which can provide us with further and future research in these areas.
Accounting for intangibles: a literature review, Cañibano, L., Garcia-Ayuso, M., & Sanchez, P. (2000). Journal of Accounting literature, 19, 102-130. In this article we take a look at the accounting methods used for intangibles and how this differs from traditional methods.
• An empirical examination of the amortized spread 1, Chalmers, J. M., & Kadlec, G. B. (1998). Journal of Financial Economics, 48(2), 159-188. In this article you will learn more about the theories that show the asset pricing suggestions and how this relates to the amortized cost of the spread in relation to the investors returns. The spread of the amortized cost measures the spreads cost over the investors holding period, which is equal to the spread times the share’s turnover rate. We take a more indepth look and examine the amortized spreads for NYSE and AMEX stocks during the period from 1983-1992. What is discovered is that the stocks with more similar spreads have a different share turnover rate. This means the stocks amortized spread is not able to be predicted by its spread alone. The consistency with this is similar to the theories of the transaction costs, where much stronger evidence is found that the amortized spreads are priced accurately.
The treatment of goodwill in the corporate balance sheet, Spacek, L. (1964). Journal of Accountancy (pre-1986), 117(000002), 35. This document shows more information on how the corporate balance sheet is kept up to date and why this is important.