From now until its mandatory effective date of 1 January 2018, we are going to consider a different element of IFRS 9 Financial Instruments on a regular basis. This month we take a look at how the treatment of modified financial liabilities measured at amortised cost will change.
Under IAS 39, if an entity modifies or exchanges a financial liability, it must determine whether that modification results in the financial liability being derecognised (the standard contains guidance about how to make this determination). This is commonly referred to as the ‘10% test’ and requires a comparison of the cash flows before and after the modification which are discounted to present value using the original effective interest rate, i.e. the difference between the original and modified amortised cost. In cases where that difference is less than 10% (unless the change arising from the modification is qualitatively significant), it is treated as a continuation of the original financial liability and, in practice, many entities amortise this difference over the remaining term of the financial liability by revising the effective interest rate.
How will this change on adoption of IFRS 9?
While IFRS 9 does not change the guidance for the modification or exchange of financial liabilities, it does clarify the requirements on accounting for the re-estimation of cash flows and introduces new requirements about how to account for the modification of financial assets that have not been derecognised. This has given rise to questions about how to account for the modification of financial liabilities that have not been derecognised – specifically whether the difference between the original and modified amortised cost should be recognised in profit or loss immediately instead of being amortised over the remaining term.
The IFRS Interpretations Committee and the IASB have recently considered this issue and tentatively concluded that, in cases where a modification or exchange of a financial liability does not result in derecognition, IFRS 9 requires that the difference between the original and modified amortised cost be recognised in profit or loss immediately. Although the conclusion is tentative, discussions at public meetings of the IASB indicate that there is no doubt about the appropriate interpretation of the requirements of IFRS 9. Consequently, amortising this difference over the remaining term of the financial liability will no longer be permitted under IFRS 9. It is worth noting that recognising an immediate gain or loss is consistent with how other revisions of estimated cash flows (except those that are due to changes in floating market rates of interest, such as LIBOR) are accounted for under both IAS 39 and IFRS 9. This approach will also be consistent with the new requirements for modified financial assets that have not been derecognised under IFRS 9. Re-estimations of cash flows arising due to changes in floating market rates of interest will still be amortised over the life of the financial instrument.
What should we do now?
Despite the fact that the decision reached remains tentative in light of concerns that were raised around transitional provisions and some possible unintended consequences, entities still need to take note of the general consensus reached on the requirements of IFRS 9.
These new requirements are not expected to affect the existing IAS 39 treatment. However, for entities that are currently amortising the difference between the original and modified amortised cost arising on modifications of this nature, this treatment will need to change upon transition to IFRS 9. At present, there are no transitional reliefs proposed. Therefore, as IFRS 9 must be applied on a retrospective basis, those entities will have to calculate any modification gains or losses relating to financial liabilities that are still recognised at the date of initial application of IFRS 9 in order to determine the required transition adjustment through opening retained earnings.
For help and advice on IFRS 9 please get in touch with your usual BDO contact or Dan Taylor.
Read more on IFRS9:
IFRS 9 explained – the classification of financial assets
IFRS 9 explained – Hedge effectiveness thresholds
IFRS 9 - Impairment and the simplified approach
IFRS 9 Explained – Available For Sale Financial Assets
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