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Over the last 18 months, the coronavirus pandemic has had an adverse impact on the global economy. Many businesses have had to adjust to these unprecedented times to continue to remain in operation. A key aspect for companies has been to ensure there is sufficient liquidity for the business to continue its operations in the short term and remain solvent. This has often resulted in companies having to closely look at their capital structure, in particular, financial liabilities or debt on the balance sheet.

There have been many instances wherein lender and borrower have agreed to modifications to debt contracts, including interest waivers, changes to interest rates, loan repayment holidays, grace period for contract violations and debt refinancing. These are modifications to financial liabilities and has accounting implications that borrowers need to closely consider. Here we look at the guidance in IFRS 9 Financial Instruments on the accounting for modification of a financial liability.

Is the modification to the financial liability substantial or not?

The financial reporting implications of modification of a financial liability depends on whether it is considered to be substantial or not. There are two tests – quantitative test and qualitative test to determine whether the modification is substantial or not.

Quantitative test: This is also referred to as the “10% test” and is applied as follows:

• Apply the original effective interest rate (EIR) to discount the cash flows under the new terms, including any fees paid net of any fees received.
• If this present value is at least 10% different from the present value of the remaining cash flows of the original financial liability, the modification is substantial.

The quantitative test compares the extent of the change between borrower and lender, so fees in this context refers to the fees between borrower and lender only. For example, it would not include fees paid to external party say a lawyer. This was clarified by an amendment to IFRS 9 Financial Instruments in the “Annual Improvements to IFRS Standards 2018-2020”.

Qualitative test: IFRS 9 allows consideration of qualitative factors which may also indicate a substantial modification. For example, a significant change in terms and conditions such as maturity date or covenants, change in the currency in which the financial liability is denominated or equity instrument embedded in new debt.

It is not necessary to meet both the above tests. For example, a borrower may conclude that the modification is substantial based only on the quantitative test.

As stated before, the financial reporting implications depend on whether the modification is substantial or not.

Modification is substantial…

If the borrower concludes that the modification is substantial, then the modification is accounted for as an extinguishment. This means that the original financial liability is removed and a new financial liability is recognised. The borrower:

• derecognises the existing financial liability and recognises a new financial liability at fair value;
• recognises a gain or loss on extinguishment, being the difference between the carrying amount and the consideration (being the fair value of new debt) in profit or loss; and
• recognises any costs or fees incurred as part of the gain or loss on the extinguishment.

When the borrower applies extinguishment accounting for substantial modifications, there are implications on the financial statements.

All the transactions costs or fees are expensed and included in the calculation of gain or loss on extinguishment. This includes the unamortised transactions costs of the original financial liability as well as additional costs or fees incurred on modification.

In addition, the fair value of the new or modified financial liability is not necessarily equal to the carrying value of the existing liability and needs to be estimated, for example, based on the expected future cash flows of the modified financial liability discounted at the market rate at which the borrower could raise similar debt.

Modification is not substantial…

If the borrower concludes that the modification is not substantial then the existing financial liability is adjusted. The borrower:

• restates the financial liability to net present value (using the original EIR as the discount rate) of modified cash flows (excluding costs and fees);
• recognises gain or loss, being the difference between the original contractual cash flows and the modified cash flows (excluding costs and fees) discounted at the original EIR, in profit or loss; and
• adjusts the carrying amount of the financial liability for costs or fees incurred which are amortised over the remaining term of the modified financial liability by calculating a revised EIR.

The costs or fees referred to above include all costs or fees, not just between the borrower or the lender. For example, the fees paid to a lawyer is included in calculation of the revised EIR.

In summary, if there is a modification of a financial liability, IFRS 9 provides guidance on the steps to be taken by the borrower. There are different financial reporting implications depending on whether the modification is substantial or not which is based on quantitative and qualitative criteria.

About the Author

Saket Modi is an IASeminars instructor on IFRS and IPSAS based in London. He has designed and facilitated courses on IFRS, in particular financial instruments, for delegates from over 50 countries in UK, Europe, Africa, Middle East and Asia. He is a qualified accountant and CFA® charterholder.