Modification of contractual cash flows

Modification due to renegotiation

When the contractual cash flows of a financial asset are renegotiated or otherwise modified and the renegotiation or modification does not result in the de-recognition of that financial asset, an entity shall recalculate the gross carrying amount of the financial asset and shall recognise 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 POCI financial assets) or, when applicable, the revised effective interest rate calculated after a fair value hedge. 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.

Modification due to revision in estimates

If an entity revises its estimates of payments or receipts (excluding modification due to renegotiation) and changes in estimates of expected credit losses), it should adjust the gross carrying amount of the financial asset or amortised cost of a financial liability (or group of financial instruments) to reflect actual and revised estimated contractual cash flows. The entity recalculates the gross carrying amount of the financial asset or amortised cost of the financial liability as the present value of the estimated future contractual cash flows that are discounted at the financial instrument’s original effective interest rate (or credit-adjusted effective interest rate for POCI financial assets) or, when applicable, the revised effective interest rate calculated after a fair value hedge. The adjustment is recognised in profit or loss as income or expense.

Example

An entity gives a loan of Rs 10,00,000 with repayment being Rs 1,50,000 every year for the next 10 years starting from the end of the first year. Calculate the effective rate of interest.

Solution

The IRR for the cash flows translates into an effective interest rate of 8.1442% and the entity will account for the interest income based on the effective interest rate as shown in the table below.

Modified cash flows and adjustment to carrying cost:

Assuming that the borrower returns Rs 2,50,000 over and above Rs 1,50,000 at the end of the fifth year, compute the adjustment to be made to the amortised cost of the loan.

Since the borrower returns Rs 4,00,000 at the end of fifth year, the entity should revise the interest income in such a way that the interest income continues to work out to the same IRR of 8.1442%. The workings are given below and the entity will pass the following journal entry. The revised interest income is also shown in the table below.

Amortized Cost computation for financial instruments

Financial Assets

The amortised cost for financial assets is computed as under:

Example 1:

X Ltd lent Rs 100,000 for two years to Mr Y with an EMI of Rs 5,000. The EIR (IRR) of this cash flow structure is 1.51% pm or 18.56% pa.

In this case, at the end of the sixth month, the amortized cost of the asset is 78,271.

Example 2:

Information as in Example 1 above, except that on maturity there will be a premium charge of, Rs 7,000. The EIR (IRR) of this cash flow structure is 1.91% pm or 22.91% pa.

In this case, at the end of the sixth month, the amortized cost of the asset is 80,545.

Financial Liabilities

The computation of the amortised cost for financial liabilities is similar to that of financial assets except there is no deduction for loss allowance.

Calculating amortized cost

Illustration

A Ltd. purchases a debt instrument with five years remaining to maturity for its fair value of Rs 1,000 (including transaction costs). The instrument has a principal amount of Rs 1,250 and carries fixed interest of 4.7% that is paid annually (Rs 1,250 x 4.7% = Rs 59 per year). Compute the amortized cost for the period of the debt instrument.

Solution

Recognition of interest revenue

Interest revenue shall be calculated by using the effective interest method. This shall be calculated by applying the effective interest rate to the gross carrying amount of a financial asset.

For purchased or originated credit-impaired (POCI) financial assets, the entity should apply the credit-adjusted effective interest rate to the amortised cost of the financial asset from initial recognition.

For financial assets that are not POCI financial assets but subsequently have become credit-impaired financial assets, the entity should apply the effective interest rate to the amortised cost of the financial asset in subsequent reporting periods.