How are financial instruments amortized?

Amortized cost is the amount at which a financial instrument is measured upon initial recognition, equal to its transaction price minus the principal repayments, plus or minus the cumulative amortization of any difference in the amount at initial recognition and its maturity using the effective interest rate (EIR) method, net of the estimated uncollectible amount – charge-offs and the allowance for loan and lease losses (ALLL).  Financial instruments classified at amortized cost are reported on the balance sheet at the present value of their expected future cash flows flows (US GAAP: contractual cash flows; IFRS: estimated cash flows) discounted at the asset’s EIR and interest revenue is calculated by applying EIR to the asset’s carrying amount at initial recognition.

Arriving at Amortized Cost

Transaction Price

− Principal Repayments

− Cumulative Amortization

= Gross Carrying Amount

− Loss Allowance (ALLL)

= Net Carrying Amount

A financial asset at amortized cost is initially recognized at its transaction price, which can be above its par value (at a premium), below par value (at a discount) or at par, with any premium or discount amortized into interest income over its term.
The effective interest-rate method is a technique for calculating the actual interest rate in a period based on the carrying value of a financial instrument at the beginning of the accounting period and to amortize the cost of the instrument at a constant rate by allocating the interest revenue or expense at that rate over its life. The effective interest rate (EIR) is the rate that provides a level yield on the financial instrument to its maturity date or next market-based repricing date equal to the rate that exactly discounts the cash flows to the net carrying amount from its initial recognition to its maturity.  The original effective interest rate of a financial instrument is its original contractual interest rate adjusted for any deferred fees or cost or any premium or discount at the origination or acquisition of the asset.

The EIR Method for Valuing an Asset
PVAsset = CF/(1 + r)n
Where:
PVAsset	= Present Value of Asset
CF	= Estimated Cash Flows
r	= Effective Interest Rate
t	= Cash Flow Periods
n	= Term of Asset
PVAsset CF1  +  CF2  +  CF3  ...+  CFn (1+r)1  (1+r)2  (1+r)3  (1+r)n

Under US GAAP, the effective interest rate is computed on the basis of the contractual cash flows over the contractual term. Under IFRS, the EIR is computed on the basis of the estimated cash flows that are expected to be received over the asset’s expected life by considering the contractual terms (e.g., prepayment, call and similar options), excluding expected credit losses.  While under US GAAP origination fees, direct origination costs, premiums and discounts are typically amortized over the contractual term, under IFRS they are amortized as part of the calculation of the EIR over the expected life of the asset.