A workout that extends a loan and cuts its coupon changes the contractual cash flows, and IFRS 9 prices that change at the loan's original rate, not the market's.
Recalculate the gross carrying amount as the present value of the modified cash flows, discounted at the loan's original effective interest rate, and book the difference in profit or loss. On an illustrative 40,000,000 loan at 5.0 per cent, extended from two to five remaining years with the coupon cut to 3.5 per cent, the new carrying amount is 37,402,314 and the modification loss is 2,597,686, 6.49 per cent. Discounting at a market rate instead would show 6,473,416, which is a fair value, not the IFRS 9 number.
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Most real estate workouts end in a modification rather than an enforcement: more time, a lower cash coupon, sometimes a paydown. For a lender reporting under IFRS 9, each of those changes the contractual cash flows, and paragraph 5.4.3 requires the gain or loss to be measured and recognised when the loan is not derecognised. The calculation is mechanical, but the choice of discount rate and the line between modification and derecognition are where it goes wrong.
| Input | Before | After |
|---|---|---|
| Principal | 40,000,000 | 40,000,000 |
| Coupon (annual, in arrears) | 5.0% | 3.5% |
| Years to maturity | 2 | 5 |
| Original effective interest rate | 5.0% | 5.0% |
| Annual interest | 2,000,000 | 1,400,000 |
The loan was originated at par with no fees, so its effective interest rate equals its coupon and its gross carrying amount before the modification is 40,000,000.
New gross carrying amount = Σ modified cash flow ÷ (1 + original EIR)t
Coupons: 1,400,000 × 4.3295 = 6,061,267. Principal: 40,000,000 × 0.78353 = 31,341,047. Total 37,402,314. In Excel: =PV(5%,5,-1400000,-40000000).
40,000,000 less 37,402,314 is a modification loss of 2,597,686, recognised in profit or loss on the date of the modification. Notice what does not create a loss: extending the loan by three years at the same 5.0 per cent coupon gives a present value of exactly 40,000,000 at the original rate, so the extension alone costs nothing in the accounts. The whole loss comes from the coupon cut, measured over the new, longer life. That is the opposite of how credit committees often see it, where the extension is the concession and the rate is a detail.
From the modification date interest income is recognised at the original 5.0 per cent on the new carrying amount: 1,870,116 in the first year against 1,400,000 of cash coupon, an unwind of 470,116. Over the five years the loan earns 9,597,686 of income in total, of which 2,597,686 is the loss coming back. A modification loss is a timing difference if the borrower performs; the credit loss, if it does not, is measured separately through the expected credit loss allowance, worked in how to calculate a loan loss provision on a defaulted CRE loan.
| New coupon | New carrying amount | Modification loss | Loss / carrying amount |
|---|---|---|---|
| 5.0% | 40,000,000 | 0 | 0.00% |
| 4.5% | 39,134,105 | 865,895 | 2.16% |
| 4.0% | 38,268,209 | 1,731,791 | 4.33% |
| 3.5% | 37,402,314 | 2,597,686 | 6.49% |
| 3.0% | 36,536,419 | 3,463,581 | 8.66% |
| 2.5% | 35,670,523 | 4,329,477 | 10.82% |
| 2.0% | 34,804,628 | 5,195,372 | 12.99% |
| Years added | Years remaining | Modification loss | Loss / carrying amount |
|---|---|---|---|
| 0 | 2 | 1,115,646 | 2.79% |
| 1 | 3 | 1,633,949 | 4.08% |
| 2 | 4 | 2,127,570 | 5.32% |
| 3 | 5 | 2,597,686 | 6.49% |
| 5 | 7 | 3,471,824 | 8.68% |
A coupon cut costs more the longer it runs, so the extension, harmless on its own, multiplies the cost of the rate concession. Below a coupon of about 2.69 per cent the loss passes 10 per cent of the carrying amount. IFRS 9 sets a quantitative 10 per cent test for derecognition only for financial liabilities; for loans held as assets there is no bright line, and many lenders apply that test by analogy alongside qualitative factors such as a change of borrower, currency or a conversion to equity. Where a modification is judged substantial, the old loan is derecognised and the new one recognised at fair value, which brings the market rate back into the answer.
Figures are illustrative. Fees exchanged on a modification, a variable original rate, or a credit-impaired loan each change the detail of the accounting; the treatment should be agreed with the auditors.
The extension against the alternatives, and how each one shows up for the lender, is modelled in the free workbook for this case.
The original effective interest rate of the loan, not the current market rate or the new coupon. On the illustrative 40,000,000 loan at 5.0 per cent, a cut to 3.5 per cent over five years gives a loss of 2,597,686 at 5.0 per cent. A 7.5 per cent market rate would give 6,473,416, which is a fair value measure instead.
Not on its own if the coupon equals the original effective rate: the new cash flows discounted at that rate still equal the carrying amount. In the illustrative case extending the 40,000,000 loan from two to five years at 5.0 per cent gives a loss of 0. Combined with a coupon cut, the extension increases the loss, from 1,633,949 over three years to 2,597,686 over five.
When the terms change substantially. IFRS 9 gives a 10 per cent present value test only for financial liabilities; for loan assets lenders use judgement, often applying that test by analogy plus qualitative factors. In the illustrative case the loss passes 10 per cent of the carrying amount once the coupon falls below about 2.69 per cent.
This article is one calculation from The Real Estate Workout. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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