Balance sheet funding considerations during times of financial distress

By Maria Ruggiero and John Kent

Debt restructuring is not a new concept, but it tends to increase in popularity at times of financial distress and the COVID‐19 pandemic is no exception.

The last wave of debt restructuring arose after the 2008‐2009 financial crisis, which led to many companies needing to apply complex accounting rules in this area under International Financial Reporting Standards (IFRS). Even in the simpler cases of debt restructuring, the accounting can be difficult to navigate and progressively more challenging when the restructuring becomes more complex and ambitious. A lesson learned from the last financial crisis was to involve IFRS assurance specialists before any restructuring is concluded to minimize the risk of unintended accounting outcomes, including shocks to profit or loss.

The current pandemic environment has led to an upturn in restructurings, resurrecting those unintended accounting outcomes. This publication shares some of the nuances and pitfalls to watch out for. However, there is no substitute for engagement with knowledgeable and experienced specialists. Deloitte welcomes the opportunity to discuss this topic with you – whether you are a borrower or a lender.

The COVID-19 corporate financial challenge

The COVID‐19 pandemic is affecting economic and financial markets globally, and virtually all industries are facing challenges associated with the economic conditions resulting from efforts to address it.

For many entities, COVID‐19 has caused financial burden and liquidity pressures. As a consequence, many borrowers have approached their lenders to ask for concessions on borrowing arrangements, for example reduced interest rates, relaxation of covenants, modification of payment terms including ‘payment holidays’ or even forgiveness of debt in exchange for equity in the borrower.

What are the consequences of amending the terms of financial instruments such as bank loans for companies who report under IFRS?

When the contractual terms of financial liabilities such as bank loans are renegotiated partway through the term, either by amending the contract or replacing the contract (‘modifications’) , borrowers need to consider the amendments carefully against the requirements of IFRS 9 Financial Instruments (IFRS 9).

What is ‘substantial modification’?

In limited circumstances, a simple qualitative assessment will be sufficient to establish that the terms of the modified debt are substantially different from those of the original, for example when the denomination of the debt is changed to a different currency.

However, most of the time, an entity will need to do a quantitative assessment, known as the ‘ten percent test.’ In other words, if the net present value of the cash flows under the modified terms, including fees, is at least ten percent different from the net present value of the remaining cash flows of the original liability, both discounted at the original effective interest rate (EIR), then the modification is considered to be substantial.