Accounting Standards Board - COVID-19 Resource - Debt Modification Accounting

Debt Modification Accounting

What you need to know (May 2020)

What’s the issue?

1. Significant reductions in rev

enue and higher operating costs due to COVID-19 are leaving many

companies struggling to make payments on their loans. To keep their businesses afloat, these

companies are working with their lenders to change terms of existing debt agreements or to obtain

waivers for debt covenants. Lenders and borrowers should closely examine changes to their debt

agreements to assess whether they are subject to modification or extinguishment accounting, as

required by IFR

9 Financial Instruments.

How s

hould the borrower account for debt modifications?

2. A borrower’s accounting depends on whether a modification is considered “substantial” or “non-

substantial.” If the terms of the debt agreement have substantially changed, the borrower should

follow the extinguishment accounting. (IFRS 9.3.3.2)

3. IFRS 9 prescribes a quantitative test to assess whether the modification is substantial. Known as the

“10 per cent test,” the borrower should first use the original effective interest rate (EIR) to discount the

cash flows under the new terms, including any fees paid net of any fees received. If this present value

is at least 10 per cent different from the present value of the remaining cash flows of the original

financial liability, the modification is substantial. (IFRS 9.B3.3.6)

4. In addition to the 10 per cent test, the borrower should consider performing a qualitative test to look at

other factors to assess whether a modification is substantial. Some factors to consider may include a

change in the currency of the loan, a significant extension on the maturity date of the loan, or a

significant change in covenants.

Debt Modification Accounting

5. If the modifications are non-substantial, the borrower should adjust the carrying amount of the

existing debt liability to reflect the revised estimated cash flow payments discounted using the original

EIR. The adjustment is recognized as a modification gain or loss. Furthermore, any costs or fees

incurred as part of the modification are also included in the carrying amount of the liability and are

amortized over the remaining term of the modified liability. (IFRS 9.B3.3.6 and IFRS 9.B5.4.6)

6. If the debt-agreement terms have substantially changed, the borrower should derecognize the

existing financial liability and recognize a new financial liability. The new financial liability is

recognized at fair value. The difference between the carrying amount and the consideration paid is

recognized in profit or loss. Any costs or fees incurred are recognized as part of the gain or loss on

the extinguishment. (IFRS 9.3.2.11, IFRS 9.3.3.2-3.3.3, and IFRS 9.B3.3.6)

How should the lender account for debt modifications?

7. IFRS 9 acknowledges that in some circumstances the modification of the contractual cash flows of a

financial asset can lead to the derecognition of the existing financial asset. However, it does not

provide further guidance for when a modification of a financial asset should result in derecognition. At

its September 2012 meeting, the

IFRS

Interpretations Committee noted that in the absence of

explicit guidance on when a modification of a financial asset results in derecognition, an analogy

might be made to the guidance on modifications of the financial liabilities. Therefore, the lender

should apply judgment and develop an accounting policy to determine whether the 10 per cent test

should be used in addition to qualitative factors to assess whether the modifications to financial

assets are substantial. For a portfolio of similar loans, the lender may consider applying an

accounting policy at the portfolio level.(IFRS 9.B5.5.25)

8. To account for modifications to financial assets that are non-substantial, the lender should recalculate

the gross carrying amount of the debt as the present value of the renegotiated contractual cash flows

that are discounted using the original EIR. The adjustment to the carrying amount of the modified

asset is recorded as a modification gain or loss in profit or loss. Any costs or fees incurred adjust the

carrying amount of the modified debt and are amortized over the remaining term of the modified debt.

(IFRS 9.5.4.3).

9. In addition to valuation of the modified debt, the lender should consider the possibility of significant

increases in credit risks and the resulting impact on the measurement of expected credit losses. To

assess whether a significant increase in credit risks has occurred, the lender should compare the risk

of a default occurring based on the modified contractual terms with the risk of a default based on the

original, unmodified contractual terms. In this assessment, the lender should consider both historical

information, such as the circumstances that led to the modification and forward-looking information,

such as the forecasted changes in business, financial or economic conditions. (IFRS 9.5.5.12 and

IFRS 9.B5.5.27)

10. Similar to a borrower’s accounting when the debt-agreement terms have substantially changed, the

lender should derecognize the existing financial asset and recognize a new financial asset. The

difference between the carrying amount (measured at the date of derecognition) and the

consideration received is recognized in profit or loss. The new financial asset is recognized at fair

AcSB COVID-19 Resource, May 2020 2

Debt Modification Accounting

value plus any costs incurred that are directly attributable to the acquisition of the new debt. (

IFRS

9.3.2.12, IFRS 9.5.1.1, and IFRS 9.B5.5.

25).

Additional considerations for breach of covenants

11. A borrower should assess how the breach of covenants on its long-term debt may affect the debt

classification on its balance sheet. If the breach occurs on or before the reporting date and provides

the lender with the right to demand repayment within 12 months of the reporting date, the debt liability

should be classified as current on the borrower’s balance sheet. (IAS 1.69(c))

12. The borrower may negotiate with the lender for a waiver to defer payments beyond 12 months from

the reporting date. Such a waiver should be obtained on or before its reporting date for the debt to be

classified as non-current. (IAS 1.74)

13. Any breach of covenants occurred, or waiver obtained after the reporting date, is considered a non-

adjusting event to be disclosed in the financial statements. (IAS 10.21)

14. In some cases, a breach on debt covenants can be so significant to the borrower that it creates

uncertainties about the borrower’s ability to continue as a going concern. Borrowers should refer to

the COVID-19 Resource “Going Concern and Liquidity Risk” for additional details.

15. The lender should closely monitor the borrower’s economic condition and financial performance. A

potential breach of covenant could signal a significantly increased credit risk that requires a lifetime

expected credit loss be recognized on the debt. An actual breach of debt covenant or a potential

bankruptcy of the borrower could indicate that the debt is impaired, resulting in a portion or the entire

debt being written off.

16. Both the lender and the borrower should perform the above assessments at each reporting period, as

judgments made in the prior interim period may need to be revisited.

Troubled debt restructuring u

nder U.S. generally accepted accounting principals (GAAP)

17. U.S. GAAP provides specific guidance on the accounting for troubled debt restructuring (TDR). A

restructuring of a debt constitutes a

TDR if the lender, for economic or legal reasons related to the

borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise

consider. Borrowers and lenders should refer to guidance in Accounting Standards Codification

(ASC) 310-40 Receivables — Troubled Debt Restructurings by Creditors, and

ASC 470-60 Debt-

Troubled Debt Restructuring by Debtors, respectively, to determine whether a change to an existing

debt arrangement represents a

TDR.

18. Financial inst

itutions should consider the March 2020 joint statement

issued by the U

.S. federal and

state prudential banking regulators that included guidance on their approach on the accounting for

loan modifications in light of COVID-19’s economic impact. Developed in consultation with the U.S.

Financial Accounting Standards Board staff, this joint statement indicates that “for short-term

modifications made on good faith basis in response to COVID-19 to borrowers who were current prior

to any relief, are not TDR

s.”

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Debt Modification Accounting

Has the IFRS

Discussion Group talked about this topic?

19. The Group has had several conversations on modifications of financial instruments. The discussions

listed may be helpful as you think how COVID-19 could affect the accounting for debt modifications:

Meeting Date

Topic

Meeting Report

June 21, 2018

Modifications or Exchanges of Fixed-rate and

Floating-rate Financial Instruments

View Document

January 10, 2018

Modifications or Exchanges of Financial Liabilities

that do not Result in Derecognition

View Document

May 30, 2017

Modifications or Exchanges of Financial Liabilities

that do not Result in Derecognition

View Document

December 3, 2015

Changes to Convertible Debt

View Document

What other resources are available?

20. Do you need more information? The following publications may provide more insight:

Resources (

IFR

Standards)

BDO, “Coronavirus impacts on the accounting for financial instruments under IFRS 9 and contract assets

under IFRS 15,”

Apri

l 2020.

KPMG, “Have borrowers considered changes to the terms of their liabilities?”

March 2020.

Resources (U.S.

GAAP

)

, Podcast, “Accounting for debt in uncertain times: 5 things to know,” Mar

ch 2020.

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Debt Modification Accounting

Extracts from relevant IFRS Standards

Standard

Guidance

IFRS 9 3.2.11

3.2.12

3.3.2

3.3.3

5.1.1

5.4.3

If, as a result of a transfer, a financial asset is derecognised in its entirety but

the transfer results in the entity obtaining a new financial asset or assuming

a new financial liability, or a servicing liability, the entity shall recognise the

new financial asset, financial liability or servicing liability at fair value.

On derecognition of a financial asset in its entirety, the difference between:

(a) the carrying amount (measured at the date of derecognition) and

(b) the consideration received (including any new asset obtained less

any new liability assumed)

shall be recognised in profit or loss.

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 (whether or not attributable to the

financial difficulty of the debtor) shall be accounted for as an extinguishment

of the original financial liability and the recognition of a new financial liability.

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.

Except for trade receivables within the scope of paragraph 5.1.3, at initial

recognition, an entity shall measure a financial asset or financial liability at

its fair value plus or minus, in the case of a financial asset or financial liability

not at fair value through profit or loss, transaction costs that are directly

attributable to the acquisition or issue of the financial asset or financial

liability.

When the contractual cash flows of a financial asset are renegotiated or

otherwise modified and the renegotiation or modification does not result in

the derecognition of that financial asset in accordance with this Standard, an

entity shall recalculate the gross carrying amount of the financial asset and

shall recognise a modification gain or loss in profit or loss. The gross

carrying amount of the financial asset shall be recalculated as the present

value of the renegotiated or modified contractual cash flows that are

discounted at the financial asset's original effective interest rate (or credit-

adjusted effective interest rate for purchased or originated credit-impaired

financial assets) or, when applicable, the revised effective interest rate

calculated in accordance with paragraph 6.5.10. Any costs or fees incurred

adjust the carrying amount of the modified financial asset and are amortised

over the remaining term of the modified financial asset.

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Debt Modification Accounting

Standard

Guidance

5.5.12

B3.3.6

B5.4.6

B5.5.25

B5.5.27

If the contractual cash flows on a financial asset have been renegotiated or

modified and the financial asset was not derecognised, an entity shall

assess whether there has been a significant increase in the credit risk of the

financial instrument in accordance with paragraph 5.5.3 by comparing:

(a) the risk of a default occurring at the reporting date (based on the

modified contractual terms); and

(b) the risk of a default occurring at initial recognition (based on the

original, unmodified contractual terms).

For the purpose of paragraph 3.3.2, the terms 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 per cent different from the

discounted present value of the remaining cash flows of the original financial

liability. If an exchange of debt instruments or modification of terms is

accounted for as an extinguishment, any costs or fees incurred are

recognised as part of the gain or loss on the extinguishment. If the exchange

or modification is not accounted for as an extinguishment, any costs or fees

incurred adjust the carrying amount of the liability and are amortised over

the remaining term of the modified liability.

If an entity revises its estimates of payments or receipts (excluding modifications

in accordance with paragraph 5.4.3 and changes in estimates of expected credit

losses), it shall adjust the gross carrying amount of the financial asset or

amortised cost of a financial liability (or group of financial instruments) to reflect

actual and revised estimated contractual cash flows. The entity recalculates the

gross carrying amount of the financial asset or amortised cost of the financial

liability as the present value of the estimated future contractual cash flows that

are discounted at the financial instrument's original effective interest rate (or

credit-adjusted effective interest rate for purchased or originated credit-impaired

financial assets) or, when applicable, the revised effective interest rate

calculated in accordance with paragraph 6.5.10. The adjustment is recognised

in profit or loss as income or expense.

In some circumstances, the renegotiation or modification of the contractual

cash flows of a financial asset can lead to the derecognition of the existing

financial asset in accordance with this Standard. When the modification of a

financial asset results in the derecognition of the existing financial asset and

the subsequent recognition of the modified financial asset, the modified

asset is considered a 'new' financial asset for the purposes of this Standard.

If the contractual cash flows on a financial asset have been renegotiated or

otherwise modified, but the financial asset is not derecognised, that financial

asset is not automatically considered to have lower credit risk. An entity shall

assess whether there has been a significant increase in credit risk since

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Debt Modification Accounting

Standard

Guidance

initial recognition on the basis of all reasonable and supportable information

that is available without undue cost or effort. This includes historical and

forward-looking information and an assessment of the credit risk over the

expected life of the financial asset, which includes information about the

circumstances that led to the modification. Evidence that the criteria for the

recognition of lifetime expected credit losses are no longer met may include

a history of up-to-date and timely payment performance against the modified

contractual terms. Typically a customer would need to demonstrate

consistently good payment behaviour over a period of time before the credit

risk is considered to have decreased. For example, a history of missed or

incomplete payments would not typically be erased by simply making one

payment on time following a modification of the contractual terms.

IAS 1 69

An entity shall classify a liability as current when:

(a) it expects to settle the liability in its normal operating cycle;

(b) it holds the liability primarily for the purpose of trading;

reporting period; or

(d) it does not have an unconditional right to defer settlement of the

liability for at least twelve months after the reporting period (see

paragra

ph 73).

Terms of a liability that could, at the option of the

counterparty, result in its settlement by the issue of equity

instruments do not affect its classification.

An entity shall classify all other liabilities as non-current.

When an entity breaches a provision of a long-term loan arrangement on or

before the end of the reporting period with the effect that the liability becomes

payable on demand, it classifies the liability as current, even if the lender

agreed, after the reporting period and before the authorisation of the financial

statements for issue, not to demand payment as a consequence of the breach.

An entity classifies the liability as current because, at the end of the reporting

period, it does not have an unconditional right to defer its settlement for at

least twelve months after that date.

IAS 10 21 If non-adjusting events after the reporting period are material, non-disclosure

could reasonably be expected to influence decisions that the primary users of

general purpose financial statements make on the basis of those financial

statements, which provide financial information about a specific reporting

entity. Accordingly, an entity shall disclose the following for each material

category of non-adjusting event after the reporting period:

(

the nature of the event; and

(b) an estimate of its financial effect, or a statement that such an

estimate cannot be made.

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