Interest-ing Times: Navigating Debt Modifications under FRS 102

One such critical decision is how to manage debt effectively. Companies often resort to negotiating delayed interest payments, extending loan terms, or opting for payment-in-kind (PIK) options to stay afloat. These debt modifications are not just strategic manoeuvres for maintaining financial health; they may also be lifelines to distressed companies.

Debt modifications come with specific accounting requirements based on the company's financial reporting framework, such as FRS 102 or IFRS. These frameworks can differ significantly, leading to varying impacts for the same transaction. This area often demands significant professional judgement, adding layers of risk and complexity. Understanding these nuances is crucial for decision-makers and finance professionals to navigate and to make the right choices for their companies.

Under both IFRS and FRS 102, different accounting treatments are required for "substantial" and "non-substantial" debt modifications. However, FRS 102 does not define "substantial" and “non-substantial”, leaving this to be a matter of Management judgement.

Often the approach in IFRS 9 (which is based on a qualitative review of the salient terms of the arrangement pre and post modification, and a quantitative comparison of the cash flows pre and post modification discounted based on the original effective interest rate to determine if they exceed a 10% differential) is applied in practice given the lack of guidance in FRS 102, however there is no obligation to do so. The obligation is simply to devise an approach which is appropriate and to apply it consistently to assessing all debt modifications. Nevertheless, the risk is that Management would be open to criticism or challenge were it to apply a different methodology; therefore, on balance, we would advocate that it is perhaps simpler to apply the IFRS 9 approach rather than to reinvent the wheel.

Substantial modifications involve derecognising the original loan and recognising a new one, with gains or losses being recognised in profit or loss and expensing related fees immediately. Non-substantial modifications adjust the loan's carrying amount and recognise the adjustment through profit or loss, with related fees typically amortised over the remaining term.

Whilst FRS 102 offers more flexibility due to the lack of a quantitative test, this can lead to various challenges and common pitfalls in practice. Common issues include:

• Misclassification of debt: Companies often fail to recognise that a loan modification could lead to a change in the classification of the debt, resulting in different accounting requirements. For example, a loan classified as “basic” under Section 11 of FRS 102 could be replaced by one that does not meet the criteria of that section and should be reclassified as an “other” financial instrument under Section 12.
• Misapplication of the 10% test: Many companies mistakenly treat the 10% test as mandatory under FRS 102 rather than an optional guideline.
• Incorrect treatment of fees: When applying the 10% test, companies often treat transaction fees incorrectly, leading to inaccurate conclusions.
• Failure to recognise embedded derivatives: Modifications can introduce “embedded derivatives” in the loan instrument that need to be separately accounted for. This is often overlooked, resulting in incorrect financial reporting.
• Inadequate disclosure: Many companies fail to provide sufficient information about modified debt.

Different outcomes based on judgement can have implications beyond debt-related financial figures, making it imperative for companies to evaluate debt modifications carefully. It is important to remember that the ripple effects of debt modifications extend beyond the immediate accounting, and therefore, the whole debt should be remodelled to ensure that the impact on future years is understood. Debt modifications can, and sometimes do, impact on distributable profits and financial ratios, including existing banking covenants.

Debt modifications have far-reaching implications, and finance teams should understand stakeholder concerns. Investors focus on financial ratios and company valuation, auditors on accurate financial reporting, and regulatory bodies on adherence to standards. Aligning with these expectations and understanding the complexities of debt modification accounting helps finance professionals navigate changes effectively, ensuring accurate financial health representation and maintaining stakeholder confidence.

How our Accounting advisory professionals can help

At Forvis Mazars, we have seen firsthand the complexities and challenges that come with debt modifications. Our team of experienced advisors will be able to help you plan for, understand and apply the accounting standards to any complex debt modification you encounter.

Get in touch