by KOH WEI CHERN
Corporate debts issued by the firms are generally accounted for as financial liabilities under International Financial Reporting Standard (IFRS) 9 Financial Instruments and in its predecessor standard, International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement. In view of the Covid-19 pandemic, more and more firms are filing for bankruptcy. Firms in slightly better situations are likely looking to restructure their corporate debts in an attempt to survive the crisis. Hence, it is an appropriate time to discuss the accounting of such financial liabilities in the case of substantial modification and/or exchange of such financial liabilities as well as in the case of less-than-substantial modification and/or exchange of such financial liabilities.
IFRS 9 paragraph 3.3.2 (International Accounting Standards Board (IASB), 2020) currently states that an exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.
IFRS 9 Appendix B Application Guidance paragraph B3.3.6 (IASB, 2020) clarified what “substantially different” means. The terms of the financial liability are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate, is at least 10% different (10% test) from the discounted present value of the remaining cash flows of the original financial liability.
In these circumstances, under IFRS 9 paragraph 3.3.3 (IASB, 2020), the difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss.
The above treatment carries forward from IAS 39.
Suppose CD Airlines Limited (CDAL) issued a three-year $1-billion bond, with annual coupon payment of 4%, for $896,916,120 on 1 January 2018. The original effective interest rate is computed to be 8%. At the end of 2019, with fears of the Covid-19 spreading and reduced travel, CDAL looked to restructure these bonds to pay a coupon payment of 2% with effect from 1 January 2020 till maturity, and with the maturity date extended from 31 December 2020 to 31 December 2022. These terms were finalised on 31 December 2019, which is CDAL’s financial year end. The bond price on the bond market was $850,000,000.
Table 1 presents the application of the formula for the 10% test required under IFRS 9 (and also IAS 39). The discounted present value of the cash flows under the new terms using the original effective interest rate is computed to be $845,374,181, and the discounted present value of the remaining cash flows of the original financial liability is computed to be $962,962,962. The difference of the two values is computed to be 12% of the former figure. Hence, under the standard(s), the financial liability is considered substantially modified.
Table 1 Determination of present values of financial liabilities on modification date
Under IFRS 9 paragraphs 3.3.2 and 3.3.3, CDAL would derecognise its original financial liability under the original terms of $962,962,962 and recognise the financial liability at its fair value of $850,000,000 (based on IFRS 9 paragraph 5.1.1), and the difference is a gain credited to the profit or loss statement.
The next question to ask would be the accounting treatment if the modification is not substantially different, that is, for non-substantially modified debts.
It is interesting to note that IAS 39 was silent on this issue. Hence, practice adopted two possible approaches. One approach (A1) was based on paragraph AG8 of IAS 39 (IASB, 2017). The intention of paragraph AG8 was to clarify the use of the effective interest rate and does not relate specifically to the accounting treatment of modified financial liabilities. IAS 39 paragraph AG8 stated that, “If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability (or group of financial instruments) to reflect actual and revised estimated cash flows. The entity recalculates the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate… The adjustment is recognised in profit or loss as income or expense.”
Another approach (A2), which was also the more common approach used in practice, based on conversations with audit firms, maintained the carrying amount of the restructured debt at restructuring date and adjusted the effective interest rate applied to the modified (but not substantially-modified) debt from restructuring date.
When IFRS 9 was first issued, IASB remained silent on this issue. Subsequently, the IFRS Interpretations Committee (IFRIC) received a request to clarify the accounting treatment on a modification or exchange of a financial liability measured at amortised cost that does not result in the derecognition of the financial liability. In March 2017, IFRIC “concluded that the principles and requirements in IFRS 9 provide an adequate basis for an entity to account for modifications and exchanges of financial liabilities that do not result in derecognition”, and did not add this to its standard-setting agenda.
IASB concurred that additional standard setting is not required. In the Basis for Conclusions to IFRS 9 (amended in October 2017), IASB “highlighted that the requirements in IFRS 9 for adjusting the amortised cost of a financial liability when a modification (or exchange) does not result in the derecognition of the financial liability are consistent with the requirements for adjusting the gross carrying amount of a financial asset when a modification does not result in the derecognition of the financial asset” (IASB, 2020, Basis of Conclusions to IFRS 9 paragraph BC4.253).
In other words, the non-substantially modified debt will be treated similarly to the modification of a financial asset under IFRS 9 paragraph 5.4.3. The entity shall recalculate the carrying amount of the non-substantially modified financial liability and recognise a modification gain or loss in profit or loss. The adjusted carrying amount of the financial liability shall be recalculated as the present value of the renegotiated or modified contractual cash flows that are discounted at the financial liability’s original effective interest rate. Hence, instead of allowing an accounting policy choice under IAS 39, IASB now requires the entity to follow A1 under IFRS 9.
Let’s continue with the CDAL example. However, in this scenario, at the end of 2019, these bonds were restructured to a coupon payment of 3% with effect from 1 January 2020 till maturity, and with the maturity date extended only to 31 December 2021.
Table 2 presents an application of the formula for the 10% test required under IFRS 9 (and also IAS 39). The discounted present value of the cash flows under the new terms using the original effective interest rate is computed to be $910,836,763, and the discounted present value of the remaining cash flows of the original financial liability is computed to be $962,962,962. The difference of the two is computed to be 5%, which is less than 10%. Hence, under the standard(s), the financial liability is considered not substantially modified.
Table 2 Determination of present values of financial liabilities on modification date
Under IAS 39, the entity could either adjust the carrying amount of the financial liability to $910,836,763 and recognise a gain of $52,126,199 to the income statement under A1 or maintain the carrying amount at $962,962,962 and adjust the effective interest rate to 5% under A2. Note that over the entire term of the financial liability, both approaches have the same financial effect. However, under A1, CDAL recognises a gain in 2019 and a higher interest expense in 2020 and 2021 relative to A2, while under A2, CDAL does not recognise a gain in 2019, but a lower interest expense in 2020 and 2021 relative to A1. Following IASB’s clarification in October 2017, only A1 is allowed under IFRS 9.
One unfavourable consequence brought forth by the Covid-19 pandemic was an increase in debt restructuring by firms trying to survive the economic fallout. Discussing the accounting treatment of modified debts is timely.
This article reviews the accounting methods of modified financial liabilities allowed under IAS 39 and IFRS 9. An accounting choice was previously allowed under IAS 39 for the accounting of non-substantially modified debts but this accounting choice is no longer allowed under IFRS 9. Implicitly allowing an accounting choice to the entities under IAS 39 could reduce comparability of financial statements among entities in this respect. Designating one accounting method under IFRS 9 allows consistency in accounting treatment among entities and could potentially enhance comparability of financial statements across firms.
Koh Wei Chern is Associate Professor, Accountancy Programme, School of Business, Singapore University of Social Sciences.
This article was first published by ISCA in the ISCA Journal in December of 2020. The original article can be viewed by clicking here