As we are gradually moving towards converged IFRS (known as IND-AS in India) in India, there are some rules which have been prescribed by the new accounting standard related to de-recognition of financial liabilities subject to the fulfillment of certain requirements.
Firstly, one needs to understand what is Financial Liability which can generally be understood in a way which is driven from a contractual obligation to deliver cash/ or other financial assets (financial asset again terms as contractual right to receive cash or other financial assets/ equity) as defined in IND-AS-32.
Unlike in current Indian accounting regime, there are no specific rules related to derecognizing such liabilities from the books of accounts. However IND-AS 109 - “Financial Instruments” covers this area specifically and requires several changes in accounting processes and systems to identify such instances and to record such de-recognition on timely manner.
A financial liability is derecognized when it is discharged or cancelled or expires for example - Payment is made to the lender, or borrower is legally released from primary responsibility or there is substantial modification in the terms of debts.
First situation is very clear and it basically talks about when a payment is being made to the lender in full and hence financial liability can be derecognized in full.
Second situation says where borrower is legally discharged from the present contractual obligation, hence in this case borrower needs to have legal release from lender stating that the new party will take over that loan and hence borrower will be discharged from its obligation and then it can be de-recognized the liability and hence an amount of difference between consideration paid and the carrying amount of that debt will be transferred to Profit and loss account.
Now, the third condition which talks about modification of terms of debt has some quantitative as well as qualitative aspects for which an entity needs to analyze if at all it meets the de-recognition criteria or will continue to show as liability in the books of accounts. Below are some practical aspects of the modification of such debts-
a. Standards talks about that if the existing terms are changed which are SUBSTANTIALLY modified from its existing form then the liability should be derecognized, and if it is so happened then we need to derecognize the existing debts from the books charging the difference amount between consideration paid and carrying amount into Profit & Loss account, and recognize a new loan(with a modified terms) at FAIR VALUE (because of the new loan should be covered with its all new conditions to reflect on face through statement of financial position unlike in normal course of new loan where we do assume that it is at arm’s length basis),
b. Now, Let's understand to ensure whether there is a substantial modification in the terms of new loan comparing to the existing loan, where the standard mentions that “terms are considered to have been substantially modified when Net Present Value of the Cash flow under the new terms (including any fees directly attributable to this new loan) differs at least by TEN PERCENT from the present value of remaining cash flow under the original terms. It means the cash flows towards the life of the loan should not more than 10% as a difference and if it is more than 10% then we cannot say there is just a modification in the existing loan & we need to de-recognize the existing loan and create a new loan at its FAIR VALUE,
c. There is no further guidance available in the standard which talks about how to calculate this 10% test, but as a general practice in industry there are some consistent approach (preferable probability based calculations for any sort of conditions like put, call or some variable rate interest options) which is being followed and the same is being documented as part of procedures to evaluate such tests,
d. The Original Effective Interest rates which is required to perform 10% test can be taken as same which would be using for amortizing (using Effective Interest Rate) the existing loan on which income would be booked.
e. There could be a situation where floating rate instruments are there and we need to know about the Original Effective Interest rate to perform this 10% test, then we need to use last reset rate as it is generally considered for such securities,
Apart from this quantitative assessment, standard talk about the qualitative test where we need to identify the facts which indicates if there is a substantial change in the terms of the debts. However, an entity can perform both Quantitative test or Qualitative test together or one after the other.
Finally the accounting for the cases where the entity finds that there is no substantial modification in the terms of debt/ instrument then the difference in the value should considered while calculating Effective Interest rate of that debt and accordingly amortization of the loan will be changed.
Also, there could be situation where such debts are being discharged by issuing equity shares subject to some scope conditions then such equity instrument will be fair valued and accordingly extinguishment will be accounted with corresponding gains/loss into Profit and Loss account.
This is overall framework about how the de-recognition will look like under IND-AS regime and indicates how an entity needs to create a robust system to ensure that these process/ principal of accounting follows properly.
The above analysis is purely based on a best practices/ practical experiences while interpreting standards and as per the Industry across the world.
The author can also be reached at anujagarwalsin@gmail.com
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