Modification gain or loss

Modification gain or loss – The amount arising from adjusting the gross carrying amount of a financial asset/hedged item to reflect the renegotiated or modified contractual cash flows in fair value hedges. The entity recalculates the gross carrying amount of a financial asset as the present value of the estimated future cash payments or receipts through the expected life of the renegotiated or modified financial asset that are discounted at the financial asset’s original effective interest rate (or the original credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets) or, when applicable, the revised effective interest rate calculated in accordance with IFRS 9 6.5.10.

When estimating the expected cash flows of a financial asset, an entity shall consider all contractual terms of the financial asset (for example, prepayment, call and similar options) but shall not consider the expected credit losses, unless the financial asset is a purchased or originated credit-impaired financial asset, in which case an entity shall also consider the initial expected credit losses that were considered when calculating the original credit-adjusted effective interest rate.

A modification gain or loss is amortised to profit or loss if the hedged item is a financial instrument (or a component thereof) measured at amortised cost or at fair value through other comprehensive income.

Background and derecognition assessment

Entity A issues a fixed rate bond to Bank B on 1 January 2012. Under the terms of the bond Entity A will pay interest annually in arrears on 31 December each year up to and including the maturity date of 31 December 2020. Interest will be paid at a rate of 4% on the principal of £100m and the principal amount will be repaid on 31 December 2020. On 1 January 2012 Entity A receives £100m (the fair value of the bond) in cash from Bank B and pays £5m in directly attributable transaction costs to third parties.

The bond is initially recognised at £95m (the fair value of the bond less directly attributable transaction costs) and subsequently accounted for at amortised cost. The EIR of the bond is calculated as 4.69%. In the absence of any modification the amortised cost of the bond at the beginning and end of each year would be as follows:

Where a number has been highlighted in green it indicates that it will be used in a calculation later in the example.

Modification gain or loss

Entity A and Bank B agree to modify the terms of the bond on 1 January 2015 as follows: Modification gain or loss

  • the maturity of the bond is extended by two years to 31 December 2022; Modification gain or loss
  • the interest rate is reduced by 0.5% to 3.5%; and Modification gain or loss
  • the principal increased by £10m to £110m. Modification gain or loss

As part of this modification, on 1 January 2015 Entity A receives £10m from Bank B and pays £1m in directly attributable transaction costs to third parties.

If the terms of the modified bond are substantially different, Entity A must derecognise the original bond and recognise the modified bond as a new financial liability. The terms are substantially different if the discounted present value of the cash flows under the modified terms, including any fees paid net of any fees received and discounted using the original EIR, is at least 10% different from the discounted present value of the remaining cash flows of the original bond liability. Modification gain or loss

For this purpose, Entity A excludes the transaction costs paid to third parties. In this case, the present value of the remaining cash flows of the original bond liability on 1 January 2015 is equal to its amortised cost carrying amount of £96.44. Entity A calculates the present value of the cash flows under the modified terms discounted at the original EIR as follows:

1 Jan

2015

31 Dec

2015

31 Dec

2016

31 Dec

2017

31 Dec

2018

31 Dec

2019

31 Dec

2020

31 Dec

2021

31 Dec

2022

Total for all periods

Cash received on modification

10.00

Interest @ 3.5%

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

Repayment of principal

(110.00)

Total cash flows

10.00

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(3.85)

(113.85)

Discount factor @ 4.69%

1.000

0.955

0.912

0.871

0.832

0.795

0.759

0.725

0.693

Present value of total cash flows

10.00

(3.68)

(3.51)

(3.36)

(3.20)

(3.06)

(2.92)

(2.79)

(78.88)

(91.40)

The difference between the present value of the cash flows under the original and modified terms is 5.2% ([91.40 96.44]/96.44 ). The difference is less than 10% and there are no other qualitative differences, therefore the modification is not substantial and is not considered an extinguishment of the original debt (i.e. it is a non-substantial modification).

Entity A must apply the requirements of IFRS 9 in relation to non-substantial modifications of financial liabilities fully retrospectively unless the financial liability has been derecognised prior to the date of initial application. Under IFRS 9, the gain or loss recognised as a result

of a non-substantial modification is equal to the difference between the present value of the cash flows under the original and modified terms discounted at the original EIR. In this case Entity A would have recognised a gain of £5.04m ( £96.44m £91.40m ) at the date of modification.

Under IFRS 9, Entity A would have adjusted the carrying amount of the bond at the date of modification in order to recognise the modification gain or loss (in addition to the adjustments made under IAS 39). The revised carrying amount as at 1 January 2015 would have been calculated as follows:

Modification gain or loss Modification gain or loss Modification gain or loss

Carrying amount (CU)

Carrying amount before modification Modification gain or loss

96.44

– Plus: cash received on modification Modification gain or loss

10.00

– Less: modification gain Modification gain or loss

(5.04)

– Less: directly attributable transaction costs Modification gain or loss

(1.00)

Carrying amount after modification Modification gain or loss

100.40

Once the carrying amount of the bond has been adjusted Entity A then recalculates the EIR to spread the directly attributable transaction costs over the life of the modified bond. The revised EIR of the bond is calculated as 4.84%. In the absence of any further modification the amortised cost of the bond at the beginning and end of each year under IFRS 9 would be as follows:

Modification gain or loss

If a non-substantial modification occurred prior to the date of initial application, and the liability continues to be recognised at the date of initial application, the carrying amount of the liability will be adjusted on transition to IFRS 9. Entity A adjusts the carrying amount of the bond to £103.59m on 1 January 2018 and recognise the corresponding adjustment of £3.39m (£106.98m £103.59m) in opening retained earnings. Modification gain or loss

 

General model of measurement of insurance contracts

Modification gain or loss   Modification gain or loss

Modification gain or loss Modification gain or loss Modification gain or loss Modification gain or loss

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