AASB 9 FINANCIAL INSTRUMENTS Q&A SERIES
The accounting consequences including the profit or loss impact arising from loan modifications differ depending on the extent to which the arrangement has been modified and the accounting policy choice made by the entity. In this article we explain the circumstances where an entity has an accounting policy choice to either revise or not revise the effective interest rate when the interest rate on a loan has been modified.
Company P has a $10 million loan from a bank with the following key terms:
Company P renegotiates the terms and the bank agrees to reduce the interest rate to 5% p.a. to reflect the current market interest rate.
The modification is determined to be non-substantial and Company P is required to recalculate the carrying amount of the loan based on the present value of the new cash flows.
*Assuming no transaction costs at the time of initial recognition
What discount rate should Company P use when recalculating the carrying amount?
Where a modification is non-substantial based on the quantitative assessment (see our article Loan modifications and derecognition), Company P has an accounting policy choice, to be applied consistently, to either:
Company P has this choice because the loan can be repaid at any time without significant penalty and the loan renegotiation was on an arm’s length basis1.
As part of the modification, the term of the loan is extended. Does Company P still have a choice of which discount rate to use?
Yes, if the modification is determined to be non-substantial based on the outcome of the quantitative test, Company P can still choose which discount rate to use when recalculating the carrying amount of the loan.
What if, under the scenario, there is a significant penalty for early repayment? Assuming the modification is non-substantial, does Company P still have a choice of which discount rate to use?
No, in this case Company P must use the original effective interest rate of 7% when recalculating the carrying amount of the loan at the date of modification and a gain will be recognised in P&L.
In accordance with AASB 9, when a debt instrument is restructured or refinanced and the terms have been substantially modified, the transaction is accounted for as an extinguishment of the old debt instrument, and the recognition of a new instrument at fair value. [AASB 18.104.22.168]
If the exchange or modification is not accounted for as an extinguishment (i.e. because the modification is non-substantial), then the amortised cost of the liability is recalculated by discounting the revised estimated future cash flows at the instrument’s original effective interest rate or, when applicable, the revised effective interest rate. [AASB 22.214.171.124]
The original contractual terms may facilitate a repricing of an otherwise fixed interest rate (or an otherwise fixed component of an interest rate) to reflect a change in periodic market rates of interest, either because the lender has a right to demand immediate repayment without significant penalty, or because the borrower has an option to prepay without significant penalty (combined with its ability to obtain alternative financing at market rates from other possible lenders).
In these cases, it appears that the entity may choose an accounting policy, to be applied consistently, to revise the original effective interest rate based on the new terms, to reflect changes in cash flows that reflect periodic changes in market rates. The revised effective interest rate would then be used to discount the modified contractual cash flows for calculation of the modification gain or loss and for subsequent calculation of amortised cost. [AASB 9 paragraphs B5.4.5 and B5.4.6]