Let's look at an example of how amortized cost accounting works.

What we've got here is a loan that's being made of a hundred million, and we've got an arrangement fee of 2 million, an annual cash interest rate of 5%, and a maturity date of four years.

Assuming all of the principle is repaid at maturity at the end of year four, all of this gives rise to an effective interest rate of 5.57%, which can be solved for using the rate or IRR function in Excel.

The effective interest rate is the internal rate of return of this loan incorporating the cost of the arrangement fees.

So in other words, someone taking out this loan is effectively facing a cost of 5.57% since they're effectively borrowing 98 after paying the arrangement fee by having to repay 100 in four years time.

How is this reflected on a balance sheet? Well, firstly, we'll see the loan asset being added to the balance sheet at 98.

That is the loan amount net of the arrangement. Fees and cash will go down because that's how much is being lent to the borrower of the loan.

Then what happens next? Well, in this case, the first item is the accrued interest, which is added to the amount owed by the borrower and the asset from the bank's perspective.

That interest amount of 5.46 can be calculated by taking the effective interest rates 5.57% and multiplying it by the beginning balance of the loan for the year, which in this case was 98, and that will give us the 5.46 million.

That's the true cost of the loan, the economic cost, and this is what is recognized as interest income in the bank's income statement, adding to the retained earnings of the bank.

Also, at the end of the first year, the bank will receive cash interest of five, which is the 100, the nominal value of the loan times the cash interest rate of 5%.

So at the moment, we have retained earnings up by 5.46 and cash up by five.

So how do we make the bank's balance sheet balance? It all comes down to the amortized cost of the loan.

The loan started at 98.

We add the accrued interest of 5.46 to the loan balance since this is owed to the bank, but we've reduced the loan balance by the cash interest of five since this has been paid to the bank and it isn't owed to the bank anymore, which means the balance of the loan increases slightly by 0.46 to 98.46.

Over time, you can see that the loan balance increases steadily until it actually reaches 100 million.

It's nominal value at the point at which it's paid off at the end of year four.

So this means that there's no gain or loss at the end of the loan's life.

Because we use the effective interest Rate to calculate interest, the balance of the loan gradually rises up to 100, which takes into account the arrangement fees, which have been spread out or amortized over the life of the loan, which is where the term amortized cost comes from.

One last thing to mention is that the market value is completely ignored in this method of accounting.

The amortized cost methodology just keeps the balance of the loan constant except for the amortization of any arrangement fees.