From the IFRS Institute – August 27, 2021
Debt arrangements are often modified, not only when a borrower is in financial difficulty but also to adjust to more favorable market financing conditions; and COVID-19 has caused economic volatility that has resulted in an even greater volume of modifications. Both IFRS Standards and US GAAP address debt modifications. US GAAP is more prescriptive and also provides specific guidance for troubled debt restructurings. Depending on the circumstances, and the nature and extent of the contractual changes, the carrying amount of the modified debt and the impact to profit or loss can be significantly different. In this article, we discuss the main differences between the two sets of standards.
Assessing if a debt modification is substantial
Under IFRS 91, accounting for a debt modification depends on whether the terms of the original debt agreement have been substantially modified. When they are substantially modified (i.e. the modification is ‘substantial’), the original debt instrument is considered extinguished and is derecognized for accounting purposes, and a new debt instrument is recognized in its place. Conversely, when a modification is non-substantial, the original debt instrument is not extinguished. Similarly, the impact to profit or loss differs based on whether the terms of the original debt have been substantially modified.
A debt modification is considered substantial under a quantitative and qualitative assessment as follows.
|Quantitative assessment (the 10% test)||
Is the net present value of the debt cash flows under the new terms different by at least 10% from the present value of the remaining cash flows under the original terms?
Cash flows are defined as net of any fees paid and/or received2 and are discounted using the effective interest rate of the original debt.
(only performed if the 10% quantitative test is not met)
In our view, the purpose of a qualitative assessment is to identify substantial differences in terms that by their nature are not captured by a quantitative assessment.
Accordingly, we believe that modifications whose effect is included in the quantitative assessment, and that are not considered substantial based on that assessment, cannot generally be considered substantial on their own from a qualitative perspective. These may include changes in principal amounts, maturities, interest rates, prepayment options and other contingent payment terms. However, if a debt instrument has an effective interest rate of zero, a change in the timing of cash flows will have no effect on the quantitative assessment, so should be incorporated into the qualitative assessment to ensure that its impact is considered.
Accounting for a modified debt arrangement
The accounting for modified debt under IFRS 9 is summarized in the following table.
|Modification is substantial||Modification is non-substantial|
|Accounting model||Extinguishment accounting: the original debt is derecognized and a new debt is recognized.||Modification accounting: the original debt is not derecognized.|
|Measurement of the debt (i.e. the financial liability)||Measure the new debt at fair value.||Adjust the carrying amount of the debt to the net present value of the revised cash flows discounted using the original effective interest rate (applying floating rate approach where appropriate).|
|Amount recognized in profit or loss||The difference between the carrying amount of the original debt and the consideration paid to extinguish it, which includes the fair value of the new debt.||The adjustment to the debt carrying amount.|
|Costs and fees incurred in the modification||Generally, include in the gain or loss on extinguishment.||
Adjust the carrying amount of the original debt and amortize over its remaining term (i.e. revise the effective interest rate of the debt).
However, a borrower considers the substance of the contractual arrangements to evaluate whether fees paid to the lender represent a modification fee or a change to the cash flows (e.g. a partial prepayment), or both.
How does US GAAP compare to IFRS 9 for debt modifications?
Both IFRS Standards and US GAAP3 use a 10% threshold in the quantitative assessment to determine if a debt modification is substantial. However, under US GAAP, the ‘gating’ question is whether the modification is a troubled debt restructuring (‘TDR’ – see difference #1 below). Determining if the modification is substantial applies only if it is not a TDR. Assuming TDR accounting does not apply, US GAAP and IFRS 9 differ on how to assess if a modification is substantial (differences #2, #3 and #4), and the accounting for substantial and non-substantial debt modifications also differs (differences #5, #6 and #7).
1. US GAAP TDR accounting does not exist under IFRS 9
Under US GAAP, the first step is to determine whether a debt modification is a TDR. If yes, TDR accounting is applied. If not, the accounting outcomes depend on whether the nontroubled modification is substantial, similar to IFRS Standards.
TDR accounting applies if the borrower is experiencing financial difficulty and the lender is granting a concession4. Both assessments may require significant judgment.
Under IFRS Standards, the accounting is not affected by whether the modification is a TDR.
2. IFRS 9 qualitative assessment does not exist under US GAAP
Unlike IFRS 9, US GAAP does not require or permit a qualitative assessment if the 10% quantitative test is not met. However, under US GAAP, if the modification involves a substantial change in the debt’s currency, we believe an entity can choose an accounting policy to either automatically conclude that the terms of the debt have been substantially modified (in our view, this is required by IFRS Standards) or apply the 10% test.
3. US GAAP specifies how to perform the 10% test; IFRS 9 is less prescriptive
US GAAP contains prescriptive guidance on how to perform the 10% test. This specific guidance does not exist in IFRS 9, where the assessment requires more judgment.
The following are examples.
i. Under US GAAP, if the original debt or the new debt has a floating interest rate, then the variable rate in effect at the date of the modification is used to calculate the cash flows of the instrument. Under IFRS 9, in our view, the following approaches may also be acceptable, as long as the selected approach is applied consistently (in each case the contractual rate is used for the remaining coupons of the original debt for which interest rate has been determined):
- use the relevant benchmark interest rate determined for the current interest accrual period according to the original terms of the debt instrument; or
- use the relevant benchmark interest rates for the original remaining term based on the relevant forward interest rate curve and the relevant benchmark interest rates for the new term of the instrument based on the relevant forward interest rate curve.
ii. Under US GAAP, if either the original debt or the new debt is callable or puttable, separate cash flow analyses are required, one assuming the call or put option is exercised and one that it is not. The analysis that generates a smaller change in cash flows forms the basis for determining whether the 10% test is met. Under IFRS 9, assuming the prepayment option is not required to be bifurcated, in our view, other approaches could also be considered to determine cash flows, including either of the following:
- calculate probability-weighted cash flows considering different scenarios, including the exercise or non-exercise of the call or put options; or
- use the outcome of the most likely scenario.
iii. Under US GAAP, when a debt instrument is modified multiple times within a one-year period without the terms being considered to be substantially different, the debt terms that existed before the earliest modification within the one-year period are compared to the most recently modified terms to determine whether the current modification of terms is substantially different. IFRS 9 provides no specific guidance in such a scenario and each modification is assessed separately.
4. US GAAP has specific rules for modifications that affect an embedded conversion option; IFRS 9 is less prescriptive
Under US GAAP, a debt modification is always considered substantial in the following circumstances.
- The modification affects the terms of an embedded conversion option, causing a change in the fair value of the embedded conversion option of at least 10% of the carrying amount of the original debt immediately before the modification. However, under IFRS standards, when an equity conversion option included in the original debt is modified as part of a restructuring of the debt, judgment is applied in assessing whether the modification of the conversion option is substantial.
- The modification adds or eliminates a substantive conversion option at the date of the modification. In our view such a modification is also substantial under IFRS Standards.
5. Non-substantial debt modifications may result in a gain or loss under IFRS 9; not under US GAAP
Unlike IFRS 9 (see above table), under US GAAP, if the debt modification is non-substantial, the carrying amount of the original debt is not adjusted and therefore no gain or loss is recognized. Instead, the effective interest rate of the debt is recalculated so that the present value of the modified contractual cash flows equals its amortized cost.
6. US GAAP treats debt modification costs paid to third parties differently from those paid to lenders; IFRS 9 does not
Like IFRS 9, under US GAAP, the accounting for fees and costs incurred in a debt modification depends on whether the modification is substantial. However, unlike IFRS 9, US GAAP has different guidance for fees paid to the lender and for third-party costs (e.g. legal fees) which may result in differences in practice.
7. US GAAP has specific rules for the treatment of fees and costs paid for the modification of undrawn line-of-credit or revolving debt arrangements; IFRS 9 does not
When a line-of-credit or revolving debt arrangement is modified, the treatment of fees and costs paid to lenders and third parties is accounted for as follows under US GAAP.
- When the borrowing capacity increases or remains the same, all such fees or costs (including unamortized deferred costs as well as costs paid at the time of modification) are deferred and amortized over the term of the new arrangement.
- When the borrowing capacity decreases, fees or costs paid at the time of the modification are deferred and amortized over the term of the new arrangement. Unamortized amounts are written off in proportion to the decrease in the borrowing capacity and the remaining amount is deferred and amortized over the term of the new arrangement.
IFRS 9 does not have similar guidance. Differences may arise in practice.
Determining if a debt modification is substantial, measuring the carrying amount of the debt and any resulting gain or loss can be a complex exercise. It may require significant judgment, in particular around the underlying terms, assumptions, calculations and conclusions. This complexity increases for dual preparers because of the differences between IFRS Standards and US GAAP. In addition, current triggers for market change (e.g. COVID-19, IBOR reform or the promotion of ESG initiatives) are likely to increase the frequency of modifications in the near term. Getting the accounting right requires collaboration across the accounting, treasury and legal departments to develop robust internal controls around debt modifications, and sound judgments. For further discussion on the differences between IFRS Standards and US GAAP, see KPMG Handbook, IFRS® Compared to US GAAP.
- IFRS 9, Financial Instruments
- IFRS 9 does not define the term 'fees' in the context of performing the quantitative assessment. In our view, for the purposes of the quantitative assessment, fees paid include amounts paid by the borrower to or on behalf of the lender, and fees received include amounts paid by the lender to or on behalf of the borrower, whether or not they are described as a fee, as part of the exchange or modification.
- ASC 470, Debt
- See chapter 4 of KPMG Handbook, Debt and equity financing