Most financial liabilities, such as borrowings, are subsequently measured at amortised cost using the effective interest method.

The initial carrying amount of a financial liability measured at amortised cost is its fair value less any transaction costs (the 'net proceeds' from issue).

A finance cost is charged on the liability using the effective rate of interest. This will increase the carrying amount of the liability:

Dr Finance cost (P/L)

Cr Liability

The liability is reduced by any cash payments made during the year:

Dr Liability

Cr Cash

Under IAS 32, the effective interest method is used to calculate the interest expense or income on financial instruments that are measured at amortized cost. The effective interest rate is the rate that exactly discounts the expected cash flows over the life of the financial instrument, considering all the contractual terms of the instrument and any other factors that may affect the timing or amount of the cash flows.

The use of the effective interest method ensures that the interest expense or income recognized in each reporting period reflects the time value of money and the credit risk inherent in the financial instrument. This is important for accurately measuring the financial performance of the entity and for making informed decisions based on the financial statements.

Here's an example of how the effective interest method is used:

Suppose a company issues a bond with a face value of $1,000 and a maturity of 5 years. The bond has an annual interest rate of 6% and pays interest annually. The bond is issued at par, so the initial measurement of the bond liability is also $1,000.

To calculate the interest expense on the bond liability for the first year, the effective interest rate is calculated based on the expected cash flows of the bond. In this case, the expected cash flows are:

Year 1: $60 (6% of $1,000)

Year 2: $60 (6% of $1,000)

Year 3: $60 (6% of $1,000)

Year 4: $60 (6% of $1,000)

Year 5: $1,060 ($1,000 principal plus $60 interest)

Using a financial calculator or a spreadsheet function, the effective interest rate for the bond can be calculated as 6.182%.

The interest expense for the first year can then be calculated by multiplying the effective interest rate by the carrying amount of the bond liability at the beginning of the year, which is $1,000. The interest expense for the first year is therefore $61.82, which is recognized in profit or loss.

In subsequent years, the same process is repeated to calculate the interest expense or income for each period, based on the carrying amount of the bond liability and the expected cash flows of the bond. This ensures that the interest expense or income recognized in each reporting period reflects the time value of money and the credit risk inherent in the bond liability.

The carrying amount of the bond liability is initially $1,000, which is also the face value of the bond. The expected cash flows for each year are based on the annual interest rate of 6% and the repayment of the principal at the end of the fifth year.

Using the effective interest rate of 6.182%, the interest expense for each year is calculated by multiplying the effective interest rate by the carrying amount of the bond liability at the beginning of the year. As the bond liability is repaid over time, the carrying amount decreases, resulting in a lower interest expense each year.

The use of the effective interest method ensures that the interest expense recognized in each reporting period reflects the time value of money and the credit risk inherent in the bond liability, providing a more accurate picture of the financial performance of the entity.