The impact of modifying a floating rate loan

Company B has a 5-year loan from a bank with the following key terms:

• 4 years until maturity
• principal of $10 million due on maturity
• interest payable quarterly based on 3-month BBSW plus a margin of 5%
• Company B can prepay the loan at any time without significant penalty
• on initial recognition Company B incurred $100,000 of transaction costs which it included in the carrying amount of the loan
• the original effective interest rate is BBSW + 5.23%, which comprises the contractual rate (BBSW + 5%) plus an adjustment of 0.23% to amortise the transaction costs over the life of the loan.

Company B renegotiates the terms and the bank agrees to reduce the margin to the current market rate of 4% p.a.

Company B incurs the following costs when modifying the loan:

• modification fee charged by the bank of $15,000
• bank legal fees paid directly to the bank’s lawyer of $12,000
• fees payable to an external advisor assisting B with the loan renegotiation of $18,000.
  

MODIFICATION ASSESSMENT

In accordance with AASB 9, when a debt instrument is restructured or refinanced and the terms have been substantially modified, the transaction is accounted for as an extinguishment of the old debt instrument, and the recognition of a new instrument at fair value. [AASB 9.3.3.2]

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. In our view, no transaction costs should be included in the initial measurement of the new liability unless it can be incontrovertibly demonstrated that they relate solely to the new liability and in no way relate to the modification of the old liability. This is not usually possible but may apply to taxes and registration fees payable on execution of the new liability [AASB 9.B3.3.6].

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. [AASB 9.5.4.3]

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. [Insights to IFRS, Chapter 7]

In applying this policy, such a change can be seen either as a modification of contractual terms (because the contractual terms have been changed), or as a re-estimation of cash flows in accordance with the original terms of the contract). [AASB 9.B5.4.5]
If the change is seen as a modification, then any costs or fees incurred adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability. [AASB 9.B3.3.6A^*]

If the change is seen as a revision of cash flows, any costs or fees incurred are recognised in profit or loss immediately. This is because they do not meet the definition of transaction costs and there is no basis to include them in the measurement of the existing financial instrument.

At the time of modification, the carrying amount of a financial liability may include an unamortised portion of costs that were included in the initial measurement of the liability. If an entity applies the accounting policy to account for a revision of the interest rate (or a component of the interest rate) of a financial liability using the guidance on floating rate financial instruments, then it appears that it should account for these unamortised original transaction costs by continuing to amortise them over the remaining term of the liability by using a post-revision effective interest rate that includes the effect of those transaction costs. This is because the liability continues to be recognised and transaction costs are amortised over the expected life of a financial instrument. [AASB 9.A, B5.4.4]

If an entity does not apply the accounting policy to apply the guidance on floating rate financial instruments, then it does not adjust the original effective interest rate in calculating the gain or loss on revision – i.e. the rate continues to include the effects of any costs that were included in the initial measurement of the asset. [AASB 9.5.4.3, B5.4.6]