To mitigate the adverse economic effects of the COVID-19 pandemic, and in recognition of the financial stress that borrowers are facing, lenders have started providing measures to borrowers under their own pre-existing or new programs. These include debt renegotiations or cash flow rescheduling of the interest or principal. Additionally, governments and central banks have launched borrower measures such as tax rebates or reliefs and government guarantees.
This begs the question of how you should account for these arrangements under IFRS 9. I’ll only be tackling modifications in this blog post, but will delve into other matters in the later posts of this series.
What are the main considerations?
To account for these arrangements appropriately — e.g. payment holidays — lenders need to perform a proper analysis to assess the following:
- Does the arrangement lead to a change of cash flows of the financial instrument, therefore leading to a substantial modification of the loan?
- Does the arrangement indicate a significant increase in credit risk (SICR), a credit impairment, or a partial write-off of the loan?
Modification of contractual cash flows
If the arrangement leads to a change in cash flows, lenders must assess whether these changes were part of the contractual terms or if the contractual cash flows were modified.
If the loan’s terms allow the borrower to demand payment holidays, then no modification exists. Lenders must carefully consider whether the borrower can defer payments without paying interest on the deferred amounts. In this case, the loan wouldn’t have met the solely payment of principal and interest (SPPI) criteria in the first place, and should have been classified as fair value through profit and loss (FVTPL) rather than amortized cost (AC).
If it’s up to the lender to grant payment holidays, no contractual obligation of the lender exists, and payment holidays would instead rather represent a modification of the contract terms.
Next, lenders should assess whether the purpose of the modification is solely to forgive a part of the cash flows. If this is the case, then this part of the financial asset needs to be derecognized according to IFRS 9 and a loss recognized. This applies in the following scenarios (IFRS 18.104.22.168):
- Specifically identified cash flows from the financial asset, e.g. interest of a loan.
- A pro-rata share of the cash flows from the financial asset, e.g. a 10 percent share of all cash flows of a loan.
- A pro-rata share of specifically identified cash flows from a financial asset, e.g. a 10 percent share of the interest cash flows of a loan.
But how do you measure the part that was forgiven? Well, there’s no clear guidance in IFRS 9, but we’ve seen that — in practice — most entities discount the forgiven cash flows at the original effective interest rate (EIR) of the asset. This approach has the same result as the modification accounting under IFRS 22.214.171.124 regarding the losses recognized and the asset amount carried forward. This treatment is discussed later in this article.
If the assessment doesn’t result in a partial derecognition, then the entire asset needs to be assessed whether it is substantially modified or not on a quantitative and qualitative basis. If the asset is substantially modified, then it needs to be derecognized and recognized again under the new terms. The difference between the carrying amount of the old asset and the fair value of the new asset must be recognized in the profit and loss (P&L).
In light of COVID-19, payment holidays are expected to be a temporary payment relief as the net economic value of the loan may not be significantly affected (i.e. the change in the overall cash flows isn’t significantly different to the asset’s present value), as stated by the European Securities and Markets Authority (ESMA) in its public statement. Therefore, the modification wouldn’t be substantial and the asset doesn’t need to be derecognized. However, this assessment must still be in line with the lender’s accounting policy, and any significant judgments made must be disclosed.
If the lender’s assessment results in the loan not being partially or completely derecognized, modification accounting must be applied according to IFRS 126.96.36.199. This means that the lender must recalculate the gross carrying amount of the financial asset by discounting the modified contractual cash flows at the original EIR. The change in the gross carrying amount is recognized immediately in the P&L.
You can refer to my article on debt restructuring that deals with assessing whether modifications are substantial or not and the relevant accounting treatment.
Finally, when looking at the impact in the P&L, the following scenarios are possible:
- If interest on the deferred payments accrues at the contractual interest rate that equals the original EIR and there are no other changes to the contractual cash flows, then there is likely to be no impact in the P&L.
- If interest on the deferred payments doesn’t accrue contractually at the same rate as the original EIR, then it’s likely that a modification loss needs to be recognized.
- If the contractual interest rate is reduced or amounts of principal and interest are forgiven, a recognition of a modification loss or even a partial write-off would be possible.
SICR, credit impairment, or partial write-off?
IFRS 9 requires judgment to be applied and entities to adjust their approaches in determining expected credit losses (ECLs) in different circumstances. Assumptions and linkages underlying how entities have implemented the ECL requirements of IFRS 9 may no longer be relevant in the current environment. Therefore, entities shouldn’t continue to apply their existing ECL methodology mechanically. Instead, they should consider how to change their approach to faithfully represent ECLs in the context of COVID-19.
To keep this post short and sweet, I’ll be publishing another post discussing the issues around this matter further.
As communicated by several regulatory bodies, careful analysis of the above-mentioned facts and circumstances is required in light of COVID-19. For the sake of transparency, any assumptions and judgments made when assessing whether a substantial modification exists or not must be disclosed.
Forward-looking information is playing a key role in the initial assessment of whether financial difficulties are due to the pandemic and that measures taken by lenders are not automatically triggering a SICR. Please read my article here if you are interested in further information on this matter.