COVID-19 Accounting Implications for CFOs - Debt Modifications
This Accounting Alert is issued to discuss the requirements of PFRS 9, Financial Instruments, and the judgment involved in determining the impact of COVID-19 in the debt modification.
The COVID-19 global pandemic has resulted in economic consequences that many reporting entities may not have had to previously consider. One of the consequences is their ability to repay loans. In response, some lenders have agreed to changing the borrowing terms or providing waivers or modification to debt covenant arrangements. Any changes to the terms of loan agreements, for example providing any kind of payments holidays on either principal or interest or changes interest rates should be carefully assessed.
Accounting for Debt Modification
Debt restructuring can take various legal forms including:
- an amendment to the terms of a debt instrument (e.g., the amounts and timing of payments of interest and principal) or
- a notional repayment of existing debt with immediate re-lending of the same or a different amount with the same counterparty. The borrower will usually incur cost in a debt restructuring, and other fees might also be paid or received. The accounting for debt modification depends on whether it considered to be "substantial" or "non-substantial".
There are two tests to check whether the modification is substantial, and these are as follows:
PFRS 9 contains guidance on non-substantial modification and the accounting in such cases. It states that costs or fees incurred are adjusted against the liability and are amortized over the remaining term. That same guidance is silent on other changes in the cash flows.
Fees Paid in a Non-Substantial Modification
In a non-substantial modification, the liability is restated based on the net present value of the revised cash flows discounted at the original EIR. This amount is compared to the previous carrying amount and the difference is recognized in the profit or loss. However, PFRS 9 specifically states in its application guidance, that costs and fees incurred are adjusted against the carrying amount. Such costs or fees therefore have some impact of altering the EIR rather than being recognized in the profit or loss.
Extinguishment account involves:
- de-recognition of the existing liability
- recognition of the new or modified liability at its fair value
- recognition of a gain or loss equal to the difference between the carrying amount of the old liability and the fair value of the new one. Any incremental costs or fees incurred, and any consideration paid or received, are also included in the calculation of the gain or loss, and
- calculating the new EIR for the modified liability, that is then used in future periods. This rate would normally equate to the market rate of interest used in the fair value calculation.
The fair value of the modified liability will usually need to be estimated. It cannot be assumed that the fair value equals the book value of the existing liability. The fair value can be estimated based on the expected cash flows of the modified liability, discounted using the interest rate at which the entity could raise debt with similar terms and conditions in the market.
The accounting alert also includes a flowchart that sets out how to assess whether a debt modification is substantial, the role of fees in the 10% test, and examples of accounting for substantial and non-substantial modifications.
See attached Accounting Alert for further details.