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7.8 Effective interest rate—expected vs contractual cash flows
Publication date: 31 Mar 2023
us IFRS & US GAAP guide
Differences between the expected and contractual lives of financial assets carried at amortized cost have different implications under the two frameworks. The difference in where the two accounting frameworks place their emphasis (contractual term for US GAAP and expected life for IFRS) can affect the asset’s carrying values and the timing of income recognition.
US GAAP | IFRS |
Under US GAAP, to determine the appropriate interest income recognition model, an entity must first consider the nature of the financial instrument, any industry-specific guidance, and the accounting model being applied to the instrument. US GAAP can be prescriptive in certain instances, such as interest income recognition for beneficial interests or structured notes.
However, generally, for loans, receivables, and debt securities, the interest method is applied over the contractual life of the asset for purposes of recognizing accretion and amortization associated with premiums, discounts, and deferred origination fees and costs. However, estimated cash flows can be used when certain criteria are met. For example, when a reporting entity holds a large number of similar loans, investments in debt securities, or other receivables for which prepayments are probable, and the timing and amount of prepayments can be reasonably estimated, an entity may elect to consider estimates of future principal prepayments in the calculation of the effective interest rate.
| Under IFRS 9, there is only one effective interest model. The calculation of the effective interest rate is based on the estimated cash flows (excluding expected credit losses) over the expected life of the asset.
Contractual cash flows over the full contractual term of the financial asset are used in the rare case when it is not possible to reliably estimate the cash flows or the expected life of a financial asset.
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Although not specifically prescribed in US GAAP, the accrual of interest income is generally suspended when the collection of interest is less than probable or the collection of any portion of the loan’s principal is doubtful (i.e., a non-performing loan). These are referred to as “non-accrual loans.”
| Under IFRS, the accrual of interest is not suspended.
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