Financial Reporting · Financial instruments

Amortised Cost and Effective Interest on Financial Liabilities

Updated 11 October 2026 · Fact-checked

Most financial liabilities, such as loan notes, debentures and redeemable preference shares, are measured at amortised cost. You record the net proceeds first, then charge finance cost each year at the effective rate on the opening balance. Subtract cash paid. The result is the closing liability.

Understand Financial Liabilities at Amortised Cost and Effective Interest

A company that issues loan notes owes money. IFRS 9 says most such liabilities are measured at amortised cost. You start with the fair value of the proceeds, less any issue costs. This is the initial carrying amount.

The cash interest paid is set by the coupon rate applied to the nominal value. But the real cost of the borrowing is higher or lower than that if the loan is issued at a discount, redeemed at a premium, or has issue costs. The effective interest rate (EIR) is the rate that discounts all future cash payments back to the net proceeds. It spreads the total cost evenly across the loan's life.

Each year, the finance cost in profit or loss is the opening liability × EIR. The cash paid is nominal value × coupon rate. The difference between the two is added to the liability. If the finance cost is bigger than the cash paid, the liability grows towards the redemption amount. By the end, the liability equals the amount repaid.

Redeemable preference shares are treated the same way. Because the company must redeem them, they are a liability, not equity. Their dividends are shown as finance costs, not as distributions.

Convertible loan notes have a debt part and an equity part. You discount the cash flows at the rate for similar debt without conversion. The result is the liability. The rest of the proceeds go to equity. The liability then runs at amortised cost.

Key rules to remember

Initial carrying amount: Net proceeds = Fair value of proceeds − Issue costs; Issue costs reduce the liability at the start. They are not expensed immediately.
Finance cost: Finance cost = Opening liability × Effective interest rate; Use the opening balance for the year, not the nominal value.
Cash interest paid: Interest paid = Nominal value × Coupon rate; This is the amount paid in cash, not the P&L charge.
Closing liability: Closing liability = Opening liability + Finance cost − Cash paid; Redemption payments are also deducted in the year they are made.
Effective rate check: Net proceeds = Σ (Cash flow ÷ (1 + EIR)ⁿ); The exam usually gives the EIR. You rarely need to solve for it.
Convertible split: Liability = PV of cash flows at the straight-debt rate; Equity = Proceeds − Liability; Equity is the balancing figure.

How to solve Financial Liabilities at Amortised Cost and Effective Interest questions

Use this method for any question on loan notes, debentures or redeemable preference shares.

1Find the net proceeds: issue price × nominal value, less issue costs. This is the opening liability.
2Note the nominal value, coupon rate, redemption amount and the EIR given in the question.
3Work out the cash interest paid: nominal value × coupon rate.
4Work out the finance cost: opening liability × EIR.
5Draw a table: opening balance, finance cost, cash paid, closing balance. Repeat for each year.
6Check the final closing balance against the redemption amount. It should match, allowing for rounding.
7Post the entries: Dr Finance cost (P&L), Cr Cash and Cr Liability for the unpaid part of the finance cost.
8Split the closing liability into current and non-current if the question asks for it. Current is the amount due within 12 months.

Quickest way: Four-column liability table

When to use it: Use this whenever you are given an EIR and asked for the finance cost or closing liability in Section A, B or C.

Write the opening balance, which is the net proceeds.
Multiply by the EIR for the finance cost.
Subtract the coupon cash paid.
Write the closing balance and carry it into the next year.
For a one-year answer, you need only one row. Do not build the whole table.

Common mistakes in Financial Liabilities at Amortised Cost and Effective Interest

Charging the coupon interest as the finance cost.
Students see the interest rate in the question and use it directly on the nominal value.
Fix: The P&L charge is always opening liability × EIR. The coupon is only the cash paid.
Expensing issue costs in the year of issue.
Issue costs look like ordinary expenses.
Fix: Deduct them from the proceeds. The EIR then spreads them over the life of the loan.
Applying the EIR to the nominal value.
The nominal value is the figure that appears in the question headline.
Fix: Always apply the EIR to the carrying amount at the start of the year.
Treating redeemable preference shares as equity and showing the dividend in the statement of changes in equity.
They are called shares.
Fix: If redemption is compulsory, they are a liability. Show the dividend as a finance cost.
Forgetting to carry forward the unpaid finance cost into the next year's opening balance.
Students reset the balance to the nominal value.
Fix: Add finance cost, deduct cash paid, and use that closing balance as next year's opening balance.
Making the equity part of a convertible a fixed percentage of the proceeds.
The split looks like a simple proportion.
Fix: Value the liability first by discounting. Equity is what is left.

Worked examples

Example 1

On 1 January 20X1, Delta issues 5% loan notes with a nominal value of ₹10,00,000 at par. Issue costs are ₹40,000. The notes are redeemed at par on 31 December 20X3. The effective rate is 6.5%. Interest is paid annually in arrears on 31 December. Calculate the finance cost for 20X1 and the liability at 31 December 20X1.

Show the solution

Net proceeds = ₹10,00,000 − ₹40,000 = ₹9,60,000.
Finance cost 20X1 = ₹9,60,000 × 6.5% = ₹62,400.
Cash interest paid = ₹10,00,000 × 5% = ₹50,000.
Closing liability = ₹9,60,000 + ₹62,400 − ₹50,000 = ₹9,72,400.

Answer: Finance cost for 20X1 is ₹62,400. The liability at 31 December 20X1 is ₹9,72,400.

Example 2

On 1 January 20X1, Omega issues 1,00,000 redeemable preference shares of ₹10 each at par. They pay a 4% dividend annually on 31 December and are redeemed at a premium on 31 December 20X2. The effective rate is 7%. Show the liability at 31 December 20X1 and the finance cost for 20X2.

Show the solution

Nominal value and proceeds = 1,00,000 × ₹10 = ₹10,00,000.
Finance cost 20X1 = ₹10,00,000 × 7% = ₹70,000.
Dividend paid = ₹10,00,000 × 4% = ₹40,000.
Closing liability 20X1 = ₹10,00,000 + ₹70,000 − ₹40,000 = ₹10,30,000.
Finance cost 20X2 = ₹10,30,000 × 7% = ₹72,100.

Answer: The liability at 31 December 20X1 is ₹10,30,000. The finance cost for 20X2 is ₹72,100.

Exam tips

In Section A and B, the question often gives the EIR. Go straight to opening balance × EIR. Do not try to derive the rate.
In a Section C question, show your table in full. Marks are given for the method even if the arithmetic is wrong.
Read whether interest is paid in arrears or in advance. It changes the opening balance used for the next year.
If a question mentions redeemable preference shares, check whether redemption is compulsory before deciding on liability or equity.
Check that the last year's closing balance equals the redemption amount. If it does not, you have an error.

Practice questions from Financial instruments

Financial Liabilities at Amortised Cost and Effective Interest in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial Liabilities at Amortised Cost and Effective Interest: frequently asked questions

What is the difference between the coupon rate and the effective rate?

The coupon rate is the rate on the nominal value that sets the cash interest paid. The effective rate is the true cost of borrowing, taking in issue costs, discounts and redemption premiums. The P&L charge uses the effective rate.

How do you calculate the finance cost on loan notes?

Multiply the opening carrying amount of the liability by the effective interest rate. For the first year, the opening amount is the net proceeds after issue costs. Later years use the prior year's closing balance.

Why are issue costs deducted from the liability?

IFRS 9 measures a financial liability initially at fair value less directly attributable transaction costs. The costs are then spread through the effective rate over the life of the debt.

How do you account for convertible loan notes?

Split the proceeds into a liability and an equity part. Discount the future cash flows at the market rate for similar non-convertible debt to get the liability. The balance goes to equity. The liability is then held at amortised cost.