Gross carrying
amount at the
amount at the end
start of the year
Interest income
Cash flows
of the year
Year (£)
(£)
(£)
(£)
2019 1,000
79
250
829
2020 829
66
250
645
2021 645
51
250
446
2022 446
36
250
232
2023 232
18
250
–
2024
–
–
–
–
3.6
Inflation-linked debt instruments
As noted in Chapter 42 at 5.1.5, the issue of debt instruments whose cash flows are
linked to changes in an inflation index is quite common. Under IAS 39, the embedded
derivative representing the variability in cash flows was often treated as closely related
to the host instrument and this practice is expected to continue for financial liabilities
under IFRS 9. IFRS 9 also often allows inflation-linked financial assets to be recorded
at amortised cost or at fair value through other comprehensive income, as shown in
Example 44.15 in Chapter 44. Entities that record these instruments at amortised cost
must apply the effective interest method to determine the amount of interest to be
recognised in profit or loss each period. In May 2008, the Interpretations Committee
was asked to consider a request for guidance on this issue. The key issue is whether the
changes in the cash flows on inflation-linked debt are equivalent to a repricing to the
market rate and, therefore, inflation-linked debt can be treated as a floating rate
instrument. Three ways of applying the effective interest method that were being used
in practice were included in the request. These are summarised in the following
example that has been revised to reflect the requirements in IFRS 9 instead of IAS 39.6
3706 Chapter 46
Example 46.13: Application of the effective interest method to inflation-linked
debt instruments7
On 1 January 2019, Company A issues a debt instrument for $100,000 that is linked to the local Consumer Prices
Index (CPI). The terms of the instrument require it to be repaid in full after five years at an amount equal to $100,000
adjusted by the cumulative change in the CPI over those five years. Interest on the loan is paid at each year end at an
amount equal to 5% of the principal ($100,000) adjusted by the cumulative change in the CPI from issuance of the
instrument. For IFRS 9 purposes, it is assumed that the debt instrument is not held for trading or designated at fair
value through profit or loss and thereby, the debt instrument is classified as subsequently measured at amortised cost.
The following table sets out the expected annual inflation rates on issuance of the instrument and one year later:
Expected annual
inflation rates
At start of
At start of
2019
2020
2019 0.7%
1.2%
2020 2.6%
1.4%
2021 2.8%
1.9%
2022 2.8%
3.5%
2023 2.8%
3.5%
During 2019 actual inflation is 1.2%.
Method 1 – application of IFRS 9.B5.4.6 (or the previous IAS 39 AG8 approach)
This approach follows the requirements set out at 3.4.1 above. In outline, it does not view the debt as a floating-
rate instrument and so calculates a fixed EIR. This is established on 1 January 2019 based on expected cash flows
at that time:
Expected
Date: end of
cash flow
Calculation
($)
2019
5,035
=5,000 × 1.007
2020
5,166
=5,000 × 1.007 × 1.026
2021
5,311
=5,000 × 1.007 × 1.026 × 1.028
2022
5,459
=5,000 × 1.007 × 1.026 × 1.028 × 1.028
2023
117,854
=105,000 × 1.007 × 1.026 × 1.028 × 1.028 × 1.028
It can be demonstrated that these expected cash flows produce an EIR of 7.4075%, i.e. the net present value
of these cash flows, discounted at 7.4075%, equals $100,000.
During 2019, A applies the EIR to the financial liability to recognise a finance charge of $7,408 ($100,000 ×
7.4075%), increasing the carrying amount of the financial liability to $107,408 ($100,000 + $7,408). At the end of
the year A pays cash interest of $5,060 ($5,000 × 101.2%) reducing the liability to $102,348 ($107,408 – $5,060). In
addition, A must adjust the carrying amount of the financial liability so that it equals the net present value of expected future cash flows discounted at the original expected interest rate as determined based on original expectations.
The expected future cash flows are now as follows:
Date: end of Cash
flow
Calculation
($)
2020
5,131
=5,000 × 1.012 × 1.014
2021
5,228
=5,000 × 1.012 × 1.014 × 1.019
2022
5,411
=5,000 × 1.012 × 1.014 × 1.019 × 1.035
2023
117,615
=105,000 × 1.012 × 1.014 × 1.019 × 1.035 × 1.035
The net present value of these cash flows discounted at 7.4075% is $102,050. Therefore A reduces its finance
charge by $298 ($102,050 – $102,348) so that the total finance charge for 2019 is $7,110 ($7,408 – $298).
Financial instruments: Subsequent measurement 3707
Method 2 – application of IFRS 9.B5.4.5 using forecast future cash flows (or the previous IAS 39 AG7 approach)
This approach is referred to at 3.3 above for simple floating-rate instruments. In outline, it calculates a
floating-rate EIR based on current market expectations of future inflation.
The initial EIR is calculated and applied in the same way as Method 1. However, no adjustment is made to
the carrying amount of the financial liability at the end of 2019 of $102,348 or to the finance charge for 2019
$7,408 ($100,000 × 7.4075%) as a result of A revising its expectations about inflation over the remaining
term of the instrument at the start of 2019.
Instead, a revised EIR is calculated at the start of 2020 using the revised forecast cash flows (shown above under
Method 1, i.e. $5,131 at the end of 2020, $5,228 at the end of 2021, $5,411 at the end of 2022 and $117,615 at
the end of 2023) and the current carrying amount ($102,348). It can be demonstrated that this produces a revised
EIR of 7.3237%, i.e. the net present value of those cash flows, discounted at 7.3237% equals $102,348.
Applying this revised rate prospectively in 2020 (and assuming estimates of future inflation are not revised
again until the start of 2021) there will be a finance charge for 2020 of $7,496 ($102,348 × 7.3237%).
Method 3 – application of IFRS 9 B5.4.4-5 without forecasting future cash flows
This method is based on the traditional method of accounting for floating-rate debt instruments and is
commonly used under other bodies of GAAP. Rather than taking account of expectations of future inflation
it takes
account of inflation only during the reporting period.
Therefore, in 2019, A would recognise a finance charge of $5,060 ($100,000 × 5% × 1.012) as a result of
accruing the variable interest payment in respect of 2019. In addition, the actual inflation experienced during
2019 increases the amount of principal that will be paid from $100,000 to $101,200 ($100,000 × 1.012%).
This increase, i.e. $1,200, is effectively a premium to be paid on the redemption of the financial liability.
IFRS 9 explains that a premium should normally be amortised over the expected life of an instrument.
However, it goes on to explain that a shorter period should be used if this is the period to which the premium
relates. [IFRS 9.B5.4.4]. In this case, the premium clearly relates to 2019 as it arises from inflation during that
year and so it is appropriately amortised in that year.
Consequently, the total finance charge for 2019 using this method would be $6,260 ($5,060 + $1,200).
In analysing the submission, it initially appeared as if the Interpretations Committee staff
completely rejected Method 3. The submission argued that Method 3 was justified by
reference to IAS 29 – Financial Reporting in Hyperinflationary Economies. The staff
concluded (quite correctly) that it was inappropriate to apply IAS 29 because that
standard applies only to the financial statements of an entity whose functional currency
is the currency of a hyperinflationary economy and instead the guidance in IAS 39
should be applied.
However, in their final rejection notice the Interpretations Committee noted that
paragraphs AG6 to AG8 of IAS 39 provide the relevant application guidance and that
judgement is required to determine whether an instrument is floating-rate and within
the scope of paragraph AG7 or is within the scope of paragraph AG8.8 Further, it was
noted that IAS 39 was unclear as to whether future expectations about interest rates
(and presumably, therefore, inflation) should be taken into account when applying
paragraph AG7. This would appear to suggest that all three methods noted in the
example would be consistent with the requirements of IAS 39 and therefore, since the
requirements are unchanged, of IFRS 9.
3.7
More complex financial liabilities
With the introduction of IFRS 9, most complex financial assets will be accounted for at
fair value through profit or loss. The treatment of financial liabilities is, however,
unchanged from that under IAS 39. The application of the effective interest method to
3708 Chapter 46
liabilities with unusual embedded derivatives that are deemed closely related to the
host, or other embedded features that are not accounted for separately, is not always
straightforward or intuitive. Specifically it is not always clear how to deal with changes
in the estimated cash flows of the instrument and in any given situation one needs to
assess which of the approaches set out above is more appropriate:
• the general requirements for changes in cash flows set out in paragraph B5.4.6 of
IFRS 9, equivalent to the previous IAS 39 AG8 approach, assuming a fixed original
EIR (see 3.4.1 above); or
• specific requirements for floating-rate instruments under paragraph B5.4.5 of
IFRS 9, equivalent to the previous IAS 39 AG7 approach (see 3.3 above).
Consider an entity that issues a debt instrument for its par value of €10m which is
repayable in ten years’ time on which an annual coupon is payable comprising two
elements: a fixed amount of 2.5% of the par value and a variable amount equating to
0.01% of the entity’s annual revenues. The instrument is not designated at fair value
through profit or loss and it is judged that the embedded feature is not a derivative as
outlined in Example 42.4 in Chapter 42.
The requirements under paragraphs B5.4.5 and B5.4.6 of IFRS 9 could give rise to
significantly different accounting treatments. In the latter case, the issuer would need to
estimate the amount of payments to be made over the life of the bond (which will
depend on its estimated revenues for the next ten years) in order to determine the EIR
to be applied. Any changes to these estimates would result in a catch-up adjustment,
based on the rate as estimated on origination, to profit or loss and the carrying amount
of the bond which, potentially, could give rise to significant volatility. In the former case
the annual coupon would simply be accrued each year and changes in estimated
revenues of future periods would have no impact on the accounting treatment until the
applicable year.
In 2009, the Interpretations Committee was asked for guidance on how an issuer should
account for a financial liability that contains participation rights by which the instrument
holder shares in the net income and losses of the issuer. The holder receives a percentage
of the issuer’s net income and is allocated a proportional share of the issuer’s losses. Losses
are applied to the nominal value of the instrument to be repaid on maturity. Losses
allocated to the holder in one period can be offset by profits in subsequent periods. The
submission was asking how the issuer should account for such instruments in periods in
which the issuer records a loss and allocates a portion of that loss to the participating
financial instruments. Two possible views were submitted to IFRIC:
• In the first view the requirements in paragraph AG8 of IAS 39 (equivalent to
paragraph B5.4.6 of IFRS 9) do not apply. Rather, the requirements for
derecognition should be applied and a gain equal to the allocated loss should be
recognised in the current period (with an offsetting reduction in the carrying
amount of the instrument).
• In a second view, the requirements in paragraph AG8 (equivalent to paragraph
B5.4.6 of IFRS 9) apply. Current period losses are one factor that the issuer would
consider when it evaluates whether it needs to revise its estimated future cash
flows and adjust the carrying amount of the participating financial instrument.
Financial instruments: Subsequent measurement 3709
The IFRIC noted that paragraphs AG6 and AG8 of IAS 39 (equivalent to paragraphs
B5.4.4. and B5.4.6 of IFRS 9) provide the relevant application guidance for measuring
financial liabilities at amortised cost using the EIR method. The IFRIC also noted that it
was inappropriate to analogise to the derecognition guidance in IAS 39 because the
liability has not been extinguished. Therefore, a gain equal to the allocated loss should
not be recognised in the current period. Rather, current period losses should be
considered together with further expectations when the issuer evaluates the need to
revise its estimated future cash flows and adjust the carrying amount of the participating
financial instrument.
It should be noted that the IFRIC considered the issue without reconsidering the
assumptions described in the request, namely that the financial liability (a) did not
contain any embedded derivatives, (b) was measured at amortised cost using the
effective interest method, and (c) did not meet the definition of a floating-rate
instrument.9 In other words, whilst clearly indicating that the B5.4.6 approach was
acceptable, it did not explicitly preclude the use of the B5.4.5 approach. In this situation,
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we believe that it would often be inappropriate to apply the requirements under
paragraph B5.4.5 of IFRS 9, principally because the entity’s revenue does not represent
a floating-rate that changes to reflect movements in market rates of interest. However,
as with the examples considered in 3.6 above, judgement is required to determine which
approach is appropriate.10
There are some financial liabilities for which re-estimation of cash flows will only
reflect movements in market interest rates but for which the use of B5.4.5 would,
arguably, not be appropriate. An example would be an ‘inverse floater’, on which
coupons are paid at a fixed-rate minus LIBOR (subject to a floor of zero).
For some financial liabilities, it might be considered appropriate to apply a combination
of both the B5.5.5 and B5.4.6 approaches. An example might be, for instance, a
prepayable floating-rate liability on which transaction costs have been incurred and that
have been included in the EIR.
3.8
Modified financial assets and liabilities
3.8.1
Accounting for modifications that do not result in derecognition
When the contractual cash flows of a financial asset are renegotiated or otherwise
modified and the renegotiation or modification does not result in the derecognition of
that financial asset, an entity recalculates the gross carrying amount of the financial asset
and recognises a modification gain or loss in profit or loss. The gross carrying amount
of the financial asset is recalculated as the present value of the renegotiated or modified
contractual cash flows that are discounted at the financial asset’s original effective
interest rate (or credit-adjusted effective interest rate for purchased or originated
credit-impaired financial assets). Any costs or fees incurred adjust the carrying amount
of the modified financial asset and are amortised over the remaining term of the
modified financial asset (see 3.8.2 below). [IFRS 9.5.4.3].
The accounting for modifications of financial assets that do not result in derecognition
is similar to changes in estimates (see 3.4.1 above), i.e. the original EIR is retained and
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 733