The topic of sustainability is gradually making its way into treasury departments as well. More and more frequently, companies are issuing so-called green bonds or green promissory note loans. These are usually financings whose proceeds must be used sustainably or invested in specifically named green projects.

In addition, sustainability-linked bonds or the term "ESG-linked" in general are also increasingly appearing in financing. These are instruments that we want to look at in more detail in this article. While green bonds are essentially earmarked, ESG-linked contracts contain clauses that can refer to different ESG goals. Examples of these ESG targets include a reduction of the company's carbon footprint or the achievement of a certain ESG rating.

Here, we want to address which accounting aspects need to be considered for these types of financing and therefore shed light on them with a view to the requirements of IFRS 9.

ESG-linked financial instruments on the asset side

If ESG-linked bonds are on the asset side of a company, IFRS 9 requires, among other things, an analysis of whether these instruments fulfil the SPPI criterion ("solely payments of principal and interest"), i.e. whether a so-called "basic lending arrangement" exists, which essentially provides for the repayment of principal and interest. At first glance, linking the amount or timing of payments to ESG criteria does not constitute a basic lending arrangement. Current discussions therefore revolve around the question of whether linking the interest rate to ESG criteria could possibly represent compensation for the company's default risk, which would facilitate compliance with the requirements of a basic lending arrangement. Without explicit proof of this, the regulations of IFRS 9 would otherwise lead to the instrument being recognised at fair value through profit or loss.

ESG-linked financial instruments on the liabilities side

However, industrial companies will often rather use these products for their own financing of the company, so that they are then on the liabilities side. While IFRS 9 has introduced many new regulations for the assets side, these have remained largely unchanged for the liabilities side. If these ESG-linked financings are accounted for at amortised cost as usual, an analysis must be carried out at the time of issuance to determine whether embedded derivatives are included and whether they must be separated.

For the existence of an embedded derivative, it must first be assessed whether the derivative definition is fulfilled for a given clause. At first glance, a linkage of the interest rate to a certain event or to a certain variable fulfils the criteria of a derivative. However, this is not the case if it is a non-financial variable that is specific to a counterparty.

For example, a linkage of the interest rate to the recycled content of materials used will typically be more of a non-financial variable specific to one of the parties to the contract. A linkage of the interest rate to the performance of a specific ESG index, such as the DAX ESG 50, would be an example of a clause that meets the criteria of a derivative and this will be separable in most cases.

In the second case, i.e. if there is an embedded derivative that must be separated, the initial recognition is done by recording both the embedded derivative and the host contract separately in the balance sheet. The derivative must be remeasured at fair value at each reporting date.

However, even the first case, i.e. there is no embedded derivative that must be separated, is not trivial with regard to subsequent accounting. In this case, the entire contract is recognised as a financial liability at amortised cost and the effective interest method is applied. The effective interest rate is determined at initial recognition on the basis of the cash flows expected at that time. If the estimate of whether the recycling rate will be achieved changes in the future, this does not lead to an adjustment of the effective interest rate, but to an adjustment of the carrying amount of the financial liability through profit or loss.

Effects on hedge accounting and the notes

In the meantime, not only original financial instruments with sustainability clauses are being concluded, but also matching ESG-linked derivatives. Typically, the question then arises as to whether these can also be designated in hedge accounting like plain vanilla derivatives. The first challenge to this can be quickly assessed: Is the company even able to value the ESG-linked derivative? It also plays an important role in the designation whether the ESG clause has been separated out as a separable derivative or not, as this has an impact on the hedged item to be designated. 

As with all accounting topics, the final assessment should only end with the consideration of whether there are special requirements for the presentation in the annual report. For example, when determining fair values, the contract-specific peculiarities must be taken into account. Also, green bonds or ESG-linked financial instruments could constitute a separate class according to IFRS 7, so that they have to be disclosed separately. 

Sources: KPMG Corporate Treasury News, Ausgabe 127, November 2022
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Andrea Monthofer, Senior Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG