• 4 Marks

CR – Nov 2018 – L3 – Q2e – Financial instruments: Recognition and measurement Corporate reporting

Discuss the accounting treatment of a variable rate loan commitment under IFRS 9 in the financial statements of Garu-Tempane Ltd.

Garu-Tempane Ltd had the following transaction during the year ended 31 December 2018:

The entity entered into a contractual commitment to make a variable rate loan to a customer beginning on 1 January 2019 for a fixed period at 1% less than the rate at which the entity (not the customer) can borrow money.

Required:
Advise the directors of Garu-Tempane Ltd on the accounting treatment of the above transaction under IFRS 9: Financial Instruments for the year ended 31 December 2018.

  • Loan Commitment as a Financial Liability:
    • A loan commitment to provide a loan at below-market interest rates is recognized as a financial liability under IFRS 9 because it obligates the entity to provide funds at a cost lower than the entity’s borrowing rate.
    • Garu-Tempane Ltd is exposed to a negative spread since the loan will be made at 1% less than the rate at which the entity itself can borrow. As a result, this creates a liability for the entity, as it incurs a loss by providing the loan at less than the cost of borrowing.
  • Initial Recognition of the Liability:
    • The loan commitment should be recognized at its fair value when the contract is entered into. This fair value would represent the present value of the expected shortfall in interest income over the loan’s term, based on the difference between the entity’s borrowing rate and the loan’s fixed rate to the customer.
    • Any initial fair value loss should be recognized in profit or loss immediately.
  • Subsequent Measurement:
    • Interest income should be recognized on the committed loan using the effective interest method, but since the loan is made at a below-market rate, the initial fair value loss may increase the liability if the interest earned does not cover the cost of borrowing.
    • At year-end, if the liability increases due to the fair value adjustment (based on IAS 37 provisions), the difference should be charged to profit or loss.
  • Conclusion:
    • The loan commitment creates a financial liability under IFRS 9, and the entity must account for the fair value loss from providing the loan at below-market rates. This should be reflected in profit or loss in the financial statements for the year ended 31 December 2018.
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