Examples illustrating possible ways of applying an expected cash flow approach to variable rate instruments
The root cause of the (additional) complexity regarding variable rate instruments is the interaction between changing interest rates and two different reference bases:
- for accounting purposes the effective interest method uses the carrying amount outstanding from time to time as the reference basis for applying the effective interest rate (EIR); and
- for contractual purposes the nominal amount is the reference basis for applying the contractual interest rate.
If the carrying amount equals the nominal amount the accounting for variable rate instruments is straightforward because the two reference bases coincide. However, once the carrying amount moves away from the nominal amount the interest revenue and the interest payments are different because of their different reference bases. While this can also occur for fixed rate instruments the contractual interest payments on these instruments allow determining the EIR as a fixed rate. In contrast, for variable rate instruments the interest payments change in response to changes in the benchmark interest curve so that it is not possible to determine an EIR that will ensure the unwinding of the carrying amount to the expected remaining cash flows without further adjustments. This issue for variable rate instruments can also arise under IAS 39 today. However, using the ECF approach would amplify this issue because the expected effective interest rate would result in the carrying amount moving away from the nominal amount given that it typically creates a differential between accounting interest and interest cash flows that reduces the carrying amount compared to the nominal amount (reflecting the initially expected credit losses).
The EIR is designed to provide a link between the carrying amount and the future expected cash flows (also) in scenarios in which the carrying amount is different from the nominal amount. However, in contrast to a fixed rate instrument, the changes in the variable interest rate prevent the carrying amount from (automatically) unwinding to the expected remaining cash flows. The numerical examples illustrate different possible ways of adjusting the amortised cost calculation in order to ensure that the carrying amount unwinds to the expected remaining cash flows after changes in the variable interest rate. The illustrated alternatives are (also refer to the general remarks on the calculations further below):
Alternatives 1A and 1B
- The expected EIR is determined as the benchmark variable interest rate plus the initial expected spread. This spread differs from the contractual spread in that it is determined as the spread that remains after all initially expected credit losses are covered (note: in the examples a significant difference between the contractual and the expected spread is used in order to better illustrate the resulting effect).
- Alternative 1A: After a change in the variable interest rate the expected EIR is reset by adjusting the expected spread. After that reset the carrying amount unwinds to the expected remaining cash flows. The reset of the expected EIR also changes the present value of the expected remaining cash flows (because discounting is based on the expected EIR) so that it equals the carrying amount.
- Alternative 1B: After a change in the variable interest rate a �catch-up� adjustment (against profit or loss) is used in order to reset the carrying amount to the present value of the expected cash flows (discounted based on the expected EIR using the initial expected spread).
- Interest revenue is determined using a �split� approach that determines interest revenue in two components � the spread and the benchmark interest rate (eg LIBOR).
- The expected spread is determined as if the instrument were a fixed rate instrument with a coupon of the contractual spread only and that coupon covers all initially expected credit losses (ie including those expected to arise on the interest payments).
- The variable (benchmark) interest is determined by reference to the nominal amount (even when the carrying amount is different). In effect, this is an �as you go� basis for this component of interest revenue.
- Because of the �split� approach the present value of the expected cash flows does not equal the carrying amount.
- If the initial estimate for expected losses needs to be revised the carrying amount will no longer unwind to the expected remaining cash flows. Hence, the carrying amount is written down to the present value of the expected remaining cash flows, which implicitly results in recognising the difference between the present value and the carrying amount that existed from initial recognition. Therefore, the �split� approach does not work any longer. Instead of the �split� approach, the interest revenue is now determined based on the carrying amount from time to time for both the initial expected spread and the variable interest component (rather than using the nominal amount as the reference basis for this component).
- If the credit losses are estimated as fixed monetary amounts rather than percentages of variable amounts this method does not require catch-up adjustments (or resets of the EIR) in order to ensure unwinding after variable interest rate changes. This scenario is illustrated in a separate, second example for Alternative 2.
General remarks on the calculations:
- The basic design is as follows:
- one workbook is used for each example (with two examples for Alternative 2).
- all examples cover five periods using different tabs for different points in time (from t0 to t4 starting with the tab to the right and moving towards the left as time progresses).
- some workbooks include tabs that illustrate possible approximations (indicated by tab names).
- changes in the interest curves occur between t1 and t2 as well as between t2 and t3; for these points in time there are two tabs if adjustments are required to ensure that the carrying amount unwinds to the expected remaining cash flows: one illustrating the difference that would arise without such adjustments and one that shows the adjustment that ensures proper unwinding.I>
- All calculations use three sets of forward rates and corresponding spot (zero) curves for:
- benchmark interest rates;
- the contractual interest rates (ie benchmark plus contractual spread); and
- benchmark interest rates plus expected spread.
- The spreadsheets include comments with more detailed remarks on the calculations.