Understanding Amortised Cost: The Measurement Model for Most SME Financial Instruments

31 Jul

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Most of the financial instruments used by SMEs, like loans, receivables, and payables, are measured using something called amortised cost. This may sound complicated, but once you understand the logic behind it, it becomes a useful and reliable tool for everyday accounting.

In this article, we explain what amortised cost really means, how it works, and how to use it in practice. We also look at how it compares to cost and fair value, and why getting this right is important for your financial statements.

What Is Amortised Cost?

Amortised cost is a method used to spread out the cost of a financial asset or liability over its life. It takes into account:

The original amount (called the initial carrying amount),
Any repayments made,
Interest income or expense earned over time, and
Any adjustments for costs or fees.

It helps you show a more accurate and fair value of the item over time, not just a flat amount.

When Do You Use Amortised Cost?

You use amortised cost for most basic financial instruments under Part I of Section 11. These include:

Trade receivables and payables,
Loans to or from banks, directors or employees,
Long-term borrowings,
Bonds and other debt instruments.

You don’t use amortised cost for:

Investments measured at cost (like some shares),
Instruments measured at fair value under Part II (like derivatives or listed shares).

What Is the Effective Interest Rate (EIR)?

To calculate amortised cost, we use the effective interest rate—the real rate of return on the instrument after considering:

Interest,
Upfront costs (like legal or arrangement fees),
Discounts or premiums.

The EIR spreads these costs or earnings over the life of the loan so that you recognise a smooth and accurate interest amount each year.

Example: 5-Year Bond Investment

You buy a bond for R950.
You also pay R50 in transaction costs.
So, your total cost is R1,000.
Each year, the bond pays R40 interest, and after 5 years it will be repaid at R1,100.

Now, we calculate the effective interest rate—the rate that spreads the return of R1,100 (plus interest) over the 5 years.

Using the EIR (calculated at about 6.9584%), here’s what your amortised cost table looks like:

(Note: Final cash received = R1,100 capital + R40 interest = R1,140)

Why Does Amortised Cost Matter?

It gives a better picture than just showing the loan or receivable at cost. It tells the full story:

It shows true interest income or expense over time.
It adjusts for fees or costs that affect the return.
It keeps the financial statements more accurate and complete.

How Is Amortised Cost Different from Cost or Fair Value?

Another Example: Loan with Upfront Fees

You borrow R100,000 from the bank. You pay a R2,000 once-off arrangement fee.

Initial carrying amount = R98,000.
You repay it over 5 years, with interest at 10%.

You don’t just expense the R2,000 once-off. Instead, you use the effective interest rate to spread it over the loan period. This increases the interest expense a little each year, making your books reflect the true cost of borrowing.

Final Thought

Understanding amortised cost helps you move beyond just recording what’s on the invoice. It ensures you report financial instruments in a way that reflects their true financial impact over time. Once you grasp how the effective interest rate works, applying it becomes second nature.

For CIBA members handling Independent Reviews or compiling AFS under IFRS for SMEs, using amortised cost correctly helps build trust and credibility in the financial reports—and keeps you aligned with the standard.

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