Modification of a prepayable fixed rate loan

Company P has a $10 million loan from a bank with the following key terms:

• 5 years remaining on the loan
• Fixed interest rate of 7% p.a.* (monthly interest of 0.583%)
• Monthly interest payments of $58,333 with $10 million principal due on maturity
• The loan can be repaid early at any time without significant penalty.

Company P successfully renegotiates the terms of the loan and the bank agrees to reduce the interest rate to the current market rate of 5% p.a. (monthly interest of 0.417%).

All other terms of the loan remain unchanged and the modification is non-substantial.

^*Assuming no transaction costs or fees

QUESTION 1

Is there a profit or loss impact when a fixed rate loan payable is renegotiated?

Interpretive response

In this scenario, no. As Company P has the ability the prepay the loan without significant penalty, the loan can be viewed as being akin to a floating rate loan.

Company P chooses as its accounting policy, to be applied consistently, to treat the loan as a floating rate loan.

In accordance with this policy, Company P revises its original effective interest rate to 5% and uses this rate to discount the re-estimated contractual cash flows (based on the new contractual rate of 5%), resulting in no change in the carrying amount of the loan and therefore no gain or loss.

In accordance with AASB 9, if the exchange or modification is not accounted for as an extinguishment (i.e. because the modification is non-substantial), then the amortised cost of the liability is recalculated by discounting the revised estimated future cash flows at the instrument’s original effective interest rate or, when applicable, the revised effective interest rate.

The original contractual terms may facilitate a repricing of an otherwise fixed interest rate (or an otherwise fixed component of an interest rate) to reflect a change in periodic market rates of interest, either because the lender has a right to demand immediate repayment without significant penalty, or because the borrower has an option to prepay without significant penalty (combined with its ability to obtain alternative financing at market rates from other possible lenders).

In these cases, it appears that the entity may choose an accounting policy, to be applied consistently, to revise the original effective interest rate based on the new terms, to reflect changes in cash flows that reflect periodic changes in market rates. The revised effective interest rate would then be used to discount the modified contractual cash flows for calculation of the modification gain or loss and for subsequent calculation of amortised cost.

[AASB 9 paragraphs 3.3.2, 5.4.3, B5.4.5 and B5.4.6]