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Practical approach to modifications of financial liabilities

modifications of financial liabilities

many companies will have to apply the IFRS 9 rules on the treatment of non-substantial modifications for the first time.

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In 2018, many companies will have to apply the IFRS 9 rules on the treatment of non-substantial modifications for the first time. In part, this will apply retrospectively for refinancing that took place already some time ago. The following article shows the quantitative effects in detail for selected examples.

Although the rules for modifications of financial liabilities in IAS 39 and IFRS 9 initially appeared unchanged, various communiqués already made it clear in 2017 that non-substantial modifications generally would lead to a modification effect reflected in the income statement, as this effect can no longer be distributed over the term with a changed effective interest rate, as is currently the practice under IAS 39.

In the following examples, we will show the differences in the treatment of non-substantial modifications and explain how these are to be treated when transitioning to IFRS 9.

Example 1:

At the beginning of 2015, a company took out a bullet loan of EUR 100 million with a term until the end of 2019. The interest rate was 4%. Taking into account transaction costs in the amount of EUR 3 million, the effective interest rate on the issue was 4.7%, resulting in the following amortization schedule:

Year Carrying amount 1.1.
Interest rate Repayment of principal Carrying amount 31.12.
2015 97,0 4,0 0,5 97,5
2016 97,5 4,0 0,6 98,1
2017 98,1 4,0 0,6 98,7
2018 98,7 4,0 0,6 99,3
2019 99,3 4,0 0,7 100,0

 

At the end of 2015, the company refinanced the loan. The term was extended by two years and the interest rate was reduced to 3%. As this modification was considered to be insubstantial, in accordance with IAS 39, a commonly used method was selected to calculate a new effective interest rate in order to spread the lower interest rate over a longer term based on the initial carrying amount of EUR 97.5 million as at the end of 2015. This effective interest rate amounted to 3.5%. Under IAS 39, amortization using the new effective interest rate results in a carrying amount of EUR 98.3 million as of 31 December 2017.

Upon the first-time use of IFRS 9 on 1 January 2018, the company had to account for the existing loan in accordance with the provisions of IFRS 9 retrospectively. It therefore had to determine the modification effect at the time of refinancing using the original effective interest rate of 4.7%, using the following calculation: 

Year Carrying amount 1.1. Interest rate Repayment of principal Carrying amount 31.12.
2015 97,0 4,0 0,5 97,5
Gains due to the modifi-cation 
      -6,2
2016 91,4 3,0 1,3 92,6
2017 92,6 3,0 1,3 94,0
2018 94,0 3,0 1,4 95,4
2019 95,4 3,0 1,5 96,8
2020 96,8 3,0 1,5 98,4
2021 98,4 3,0 1,6 100,0

 

The interest savings are therefore not spread over the term but recognized in the income statement at the time of refinancing in the amount of EUR 6.2 million. The gains made due to the modification mainly result from the interest amounting to EUR 4 million saved for the original term, the interest rate that was lowered by 1.7% for the last two years compared to the effective interest rate, and a modified distribution of the original transaction costs.

When preparing the opening balance sheet, the difference resulting from the amount under IAS 39 (see above, EUR 98.3 million) and the carrying amount under IFRS 9 (see table, EUR 94 million) of EUR 4.3 million was recognized not affecting operating result as of 31 December 2017. This difference is reflected in a correspondingly higher interest expense in subsequent periods, which, in contrast to the transitional entry on 1 January 2018, is recognized in profit or loss.

Example 2:

In this example, the above loan is now modified to the effect that it was increased by an additional EUR 50 million as agreed at the time of refinancing. The company does not regard the increase in the loan as a new loan. In this case, the gains due to the modification jump to EUR 10.5 million. This results mainly from the interest savings described above, but now of course for 150% of the amount borrowed. 

Year Carrying amount 1.1. Interest rate Repayment of principal Carrying amount 31.12.
2015 97,0 4,0 0,5 97,5
Gains due to the modifi-cation        -10,5
Loan increase       50,0
2016 137,0 4,5 1,9 138,9
2017 138,9 4,5 2,0 141,0
2018 141,0 4,5 2,1 143,1
2019 143,1 4,5 2,2 145,3
2020 145,3 4,5 2,3 147,6
2021 147,6 4,5 2,4 150,0

 

Conclusion: At the time of the transition to IFRS 9, the main challenge was to determine correct carrying amounts for the opening balance sheet in accordance with IFRS 9. Particularly in the case of multiple refinancing events in the past, determining the carrying amount is complex. Because the interest rates in the past were generally higher, significant adjustments to the effective interest rates used have been observed. The associated changes in carrying amounts and future interest expenses may also lead to differences in the company’s performance indicators or its contractual covenants, which should therefore also be analyzed in this context.

However, a non-substantial modification does not always lead to the effects described above. If a variable-rate loan is modified, it may be appropriate to use an adjusted effective interest rate for subsequent accounting rather than the original effective interest rate, with reference to IFRS 9B.5.4.5. What has to be examined in detail is which contractual parameters were changed and whether the change represents an adjustment to market conditions. In order to be able to determine the appropriate accounting approach as well as any gains or losses arising from the modifications, a detailed case-by-case analysis is indispensable.

Source: KPMG Corporate Treasury News, Edition 87, December 2018

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