What is amortized cost?

Introduction

The amortized cost falls under-investment category and method to accounting which requires financial assets under amortized cost method to be reported on balance sheet date at amortized cost which should equal to initial acquisition amount fewer deductions for principal repayment and adjustments amortization or impairment if any.

It is a presentation category allowed by IFRS 9. The amortized cost method is generally applied to debt instruments fulfilling the following conditions:

  1. The business consists of such financial assets to collect contractual cash flows and not selling the asset to realize any capital gains.
  2. The contractual cash flow of specific financial asset under consideration is on account of repayment of principal and interest and they occur on specified dates.

Amortized cost measurement requires the application of the effective interest method. Gains and losses resulting from fluctuations in fair value are not recognized for financial assets classified in the amortized cost measurement category.

Cost and amortized cost accounting

Cost accounting assumes that a money market instrument purchased upon issuance and held until maturity, should be priced at cost.

Amortized cost accounting assumes that a money market instrument, acquired after issuance and held until maturity, should be priced at its acquisition cost and any difference between its acquisition cost and par value should be realized on a straight-line basis between acquisition and maturity.

What are the risks associated with amortized cost accounting?

Amortized cost accounting is a reasonable way of evaluating the fair value of money market instruments, and, in certain instances, is authorized by accounting standards or is used as a proxy for the fair value specified by accounting standards.

Amortized cost accounting may provide an accurate estimate of the market price for certain short-term instruments, assuming that they will mature at par.

However, sudden movements in interest rates or credit concerns may cause material deviations between the mark-to-market price and the price calculated using the amortization method.

In addition to the risk of mispricing of individual instruments, the use of amortized cost accounting could create opacity for investors regarding the actual net asset value of the funds.

Accordingly, the use of amortized cost accounting should be subject to strict conditions and monitoring

The reasoning for Use of Amortized Cost

On several occasions, the FASB has indicated a strong preference for fair value as a general objective.

But there has been a great deal of opposition from many quarters, and the FASB has tended to determine the appropriate measurement attribute for particular instruments (fair value, amortized cost, etc.) in different projects based on the facts and circumstances in each case.

Preparers have generally favored the use of amortized cost for instruments that an entity intends to hold and realize its benefits through a collection of contractual cash flows.

Amortized cost accounting recognizes reported interest as the primary “earnings” of the entity and also places emphasis on the timing of the realization of changes in value by the entity rather than simply on the amount of the change in value.

According to the SEC regulations, the use of the amortized cost method of accounting for investments in securities by money market mutual funds must be justified on an entity-by-entity basis.

Therefore, it may not be fully representative to evaluate the application of this method using broad industry data.

Conclusion

The amortized cost method of accounting is supported by the very short-term duration, high quality, and hold-to-maturity nature of most of the investments held.

Amortized cost does not necessarily have any relationship between the adjusted cost of an asset and market value. Market value could potentially be much higher or lower than the original cost of an asset net of its amortized cost.

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