Contract modifications under IFRS 9 Financial Instruments
With instances of contract modifications to financial liabilities expected to increase as a result of the COVID-19 pandemic, this short guide outlines the accounting requirements of IFRS 9 Financial Instruments and illustrates their application with an example. Aimed at non-banking entities, it discusses the accounting for contract modifications to financial liabilities only.
This ICAEW Know-How was created by the Financial Reporting Faculty.
Loan repayment holidays, interest waivers and other renegotiations of debt finance will be an increasingly common occurrence for entities as a result of the global pandemic. Particularly for those that have not dealt with such scenarios previously, accounting for these contract modifications may present challenges. It is also worth noting that accounting requirements for non-substantial modifications of financial liabilities were clarified with the introduction of IFRS 9 Financial Instruments, effective since 2018, and may represent a change compared to treatments applied previously.
Is it a modification or not?
The first step in the process is to establish whether the changes agreed with the lender constitute a modification or derecognition event in the eyes of IFRS 9. The term modification is not defined in IFRS 9 but the normal meaning implies that the contractual terms of the existing debt are renegotiated or altered in some way. An exchange of debt instruments between an existing borrower and a lender, although not a modification in this sense, is treated in the same way.
However, the repayment of a financial liability in line with the terms of the original contract eg, by exercising an option to repay a loan early followed by taking out new debt is not a modification. This would instead be accounted for as a derecognition of the existing liability and the recognition of a new liability.
Is it a substantial or non-substantial modification?
Having established that a modification exists, it is then necessary to determine whether it constitutes a substantial or non-substantial modification. Two tests are potentially considered:
- first, the quantitative test;
- and second, if necessary, the qualitative test.
Under the quantitative test, the modification is classed as substantial if the present value of the modified cash flows is at least 10% different to the present value of the remaining original cash flows. For the purpose of this test, when calculating the present value of the modified cash flows any fees paid or received  should be included and cash flows should be discounted at the original effective interest rate.
 The Annual Improvements to IFRS Standards 2018-2020 clarify that for the purposes of the 10% test the borrower includes only fees paid or received between the borrower and the lender. The amendments are effective for annual periods beginning on or after 1 January 2022, with early application permitted.
There may be circumstances where the 10% test is not met, but other qualitative factors indicate there has been a substantial modification. Although not required by the standard, IFRS 9 permits qualitative factors to be considered. For example, where the denomination of a liability is changed to a different currency, it may be concluded that the terms of the modified liability are substantially different.
Accounting for substantial modifications
Substantial modifications are treated as an extinguishment, and so derecognition, of the existing liability and recognition of a new liability based on the new contractual terms. Any difference is recognised as a gain or loss within profit or loss. Costs or fees incurred are also recognised within profit or loss as part of the gain or loss on extinguishment.
Accounting for non-substantial modifications
IFRS 9 requires the amortised cost of the liability to be recalculated by discounting the modified contractual cash flows (excluding costs and fees) using the original effective interest rate. Any change to the amortised cost of the financial liability is required to be recognised within profit or loss at the date of the modification.
The carrying amount of the liability is then further revised for any costs or fees incurred. The effective interest rate is also revised accordingly, so the costs are amortised over the remaining term of the modified liability.
As noted earlier, IFRS 9 clarifies the requirement to recognise an immediate gain or loss on non-substantial modifications. The treatment required under the previous accounting standard, IAS 39 Financial Instruments: Recognition and Measurement was ambiguous and typically, entities did not recognise an immediate gain or loss. Instead, directly attributable transaction costs and revisions to future contractual cash flows were considered in the calculation of a revised effective interest rate. The effects of the modification were therefore spread over the remaining term of the financial liability. As a result of this clarification, some entities may find themselves having to account for contract modifications differently than compared to the past.
A company takes out a £10m loan on 1 January 2019, repayable after 5 years, on 31 December 2023. Interest is charged at 5% per annum, payable annually on 31 December. Transaction costs of £250,000 were paid on 1 January 2019. The effective interest rate was calculated as 5.59%.
As a result of the COVID-19 pandemic, the company negotiates a modification of the terms its loan on 31 December 2020 and the modification results in the waiver of the interest payment due on the same date. All other contractual cash flows remain payable. Fees of £100,000 were paid to in respect of this negotiation.
The loan was initially recognised on 1 January 2019 at fair value, being the transaction price of £10m, less the transaction costs of £250,000 ie, at £9.75m.
For the year ended 31 December 2019, the loan was subsequently measured at amortised cost as follows:
|Initial recognition at 1 January 2019||Interest expense to profit or loss at 5.59%||Interest paid (5% x £10,000,000)||Carrying value at 31 December 2019|
For the year ended 31 December 2020, the interest expense recognised in profit or loss would be calculated using the effective interest rate:
5.59% x £9,795,025 = £547,542
giving rise to a carrying value of £10,342,567 (£9,795,025 + £547,542) immediately prior to the 31 December 2020 year-end. Prior to the year-end, it would then be necessary to determine whether the modification that occurs on 31 December 2020 constitutes a substantial or non-substantial modification.
The present value, discounted using the original effective interest rate of 5.59%, of the remaining contractual cash flows of the original liability and the modified contractual cash flows including modification fees would be calculated as follows:
|Date of cash flow||Remaining original contractual cash flows||Modified contractual cash flows|
|31 December 2020 (now)||£500,000||£100,000 (fees, no interest)|
|31 December 2021||£500,000||£500,000|
|31 December 2022||£500,000||£500,000|
|31 December 2023||£10,500,000||£10,500,000|
|Present value, discounted at 5.59%||£10,341,088||£9,941,088|
The present value of modified cash flows is 3.87% different to the present value of the remaining original cash flows. Assuming no qualitative factors indicate this is a substantial modification, it will be classified as a non-substantial modification.
At 31 December 2020, the current carrying value of the liability of £10,342,567 is adjusted to the present value of the modified cash flows, excluding costs, being £9,841,088 (£9,941,088 calculated above, excluding £100,000 cash flow of fees). A gain of £501,479 (£10,342,567 - £9,841,088) is therefore recognised in profit or loss in the year ended 31 December 2020.
The carrying value of the liability is then further adjusted to reflect the fees paid of £100,000. The liability is decreased to £9,741,088 and the effective interest rate revised to 5.97% (calculated using IRR function in spreadsheet programme). From 1 January 2021, the amortised cost measure will become:
|Opening balance at 1 January||Interest expense to profit or loss at 5.97%||Telephone helpline||Telephone helpline|
|Year-end 31 Dec 2021||£9,741,088||£581,543||(£500,000)||£9,822,631|
|Year-end 31 Dec 2022||£9,822,631||£586,411||(£500,000)||£9.909,042|
|Year-end 31 Dec 2023||£9,909,042||£591,570||(£10,500,000)||£0*|
* subject to rounding
Further resources on IFRS 9 Financial Instruments are accessible at icaew.com/ifrs9
For more guidance on the requirements of IFRS and UK GAAP visit icaew.com/financialreporting
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