The following scenarios and questions were initially published by Wiley Insight IFRS

## Scenario One

At the reporting date, Entity A enters into an interest only loan of CU1 million repayable in ten years’ time with interest of CU 100,000 payable annually. Under IFRS, the loan would be recorded at the reporting date at CU1 million (ignoring transaction costs). Assume that the present value at the reporting date of the CU 100,000 interest payable at the end of the reporting period is CU 92,500.

## Scenario Two

At the reporting date, Entity B borrows CU5 billion over 30 years. Payments of CU600 million, comprising principal and interest are due at the end of each year. Under IFRS, the loan would be recorded at the reporting date at CU5 billion (ignoring transaction costs). At the end of the first year, the principal component of the payment of CU600 million is CU60 million. Assume that the present value at the reporting date of the CU600 million payable at the end of the reporting period is CU550 million and the present value at the reporting date of the principal component of the payment is CU55 million.

- In Scenario One, what portion, if any, of the CU1 million should Entity A classify as a current liability at the reporting date?

- For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Debt that is accounted for at amortised cost requires that the interest cost of the debt be allocated to periods using the effective interest rate, which is the rate that exactly discounts estimated future cash payments through the life of the financial instrument to the net carrying amount of the liability. Therefore at any time, the current carrying amount of the liability is equal to the present value of all future cash payments. To consider this from the opposite direction of time, the principal amount of the debt compounds at the effective interest rate during the life of the instrument.

On each anniversary date when the interest is paid, the present value of all future cash flows will be CU1 million. In the example, since the interest is only paid annually, this relationship will not hold true – assume interest for the year is paid on December 31. Between January 1 and December 30 of the following calendar year the future cash outflows remain the same in nominal dollars, however, the time period over which they are discounted changes (the time period decreases as the year progresses).

Therefore the effect of the discount becomes less, and the carrying amount of the liability increases. This increase in the liability is the interest cost which is accrued but not yet paid. This change in the carrying amount of the liability only occurs because the interest is paid annually (this effect would disappear if interest was paid daily). At all times the CU1 million loan will be presented as long term, and the difference between the CU1 million and the present value of the instrument, namely the accrued interest, will be shown as current.

The amount of the accrued interest will not be the same as the present value of the next interest payment. Instead, the carrying amount of the debt at the reporting date will be the present value of all future cash flows. Individual cash flows are not discounted. This can be seen in the response below to Scenario Two.

- In Scenario Two, what portion, if any, of the CU5 billion should Entity B classify as a current liability at the reporting date?
- For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Assuming the calculation as presented in the scenario is correct, the CU60 million portion of the combined principle and interest payment should be presented as the current component of the debt. The present value of this amount is not relevant to the current versus long term classification question. Recall the effective interest method described above: the total of the cash flows are discounted to determine the carrying amount of the debt. Therefore the CU5 billion on initial recognition is the discounted amount of those total cash flows. The CU60 million principle component is a portion of that principle balance, that is, it is discounted already. If it was discounted again to determine the classification, then we would be doubly discounting the amount.

By constructing an amortization table for the loan it can proved that the effective interest rate is approximately 11.547776%. I am clarifying the scenario by assuming the loan is entered into on the last day of one reporting period and the first repayment is made on the last day of the following reporting period (year 1 in the table following).

year |
initial loan | interest | repayment | closing
balance |

1 | 5,000,000,000 | 577,388,800 | (600,000,000) | 4,977,388,800 |

2 | 4,977,388,800 | 574,777,709 | (600,000,000) | 4,952,166,509 |

3 | 4,952,166,509 | 571,865,096 | (600,000,000) | 4,924,031,605 |

>>> | ||||

28 | 1,452,373,314 | 167,716,817 | (600,000,000) | 1,020,090,131 |

29 | 1,020,090,131 | 117,797,723 | (600,000,000) | 537,887,854 |

30 | 537,887,854 | 62,114,085 | (600,000,000) | 1,939 |

The table illustrates the effective interest method: interest calculated at this effective rate on the opening balance each period with combined principle and interest payments of CU600 million at the end of each year leaves a zero balance after 30 years.

From the table the closing principle balance at the end of the first year, after making the first repayment, is CU4,977 million. Therefore of the CU5 billion initial debt, CU23 million is due within one year and is presented as current, and the remaining CU4,977 million is presented as long term. The principle and interest components of the CU600 million payments are not individually discounted.

- For both scenarios state the amount you believe should be classified as current in accordance with the requirements of the standard. Please provide a rationale for your view.

The current balances for each of these instruments have previously been referred to.

From my experience, reporting entities in the Canadian jurisdiction would also take the approach described above in measuring current liabilities. The rationale, which I agree with, is based on the principle stated in the preamble, and that principle represents the definition of the amortised cost of a financial liability. The definition from IAS 39 paragraph 9 reads, “The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principle repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount…”

Applying this calculation method to the future cash flows for Scenario Two is a proof (effectively performing the calculation in reverse) of the amortization table presented above. Performing the calculation at the opening and closing dates for any year proves the amounts presented in the table. Logically, the difference between those two amounts is the amount of principle repaid during the period which should therefore be presented as current on the statement of financial position.