Fiscal relief and accounting considerations on the road to recovery Part 1

Rosalie T. Lapuz and Leomar G. Velez

(First of two parts)

According to the Organisation for Economic Co-operation and Development (OECD) Economic Outlook Interim Report issued in September, global economic output collapsed in the first half of 2020, but recovered swiftly following the easing of measures to contain the COVID-19 pandemic and the initial re-opening of businesses.

The report also noted that what prevented greater economic decline were economies that introduced prompt and effective policy support to cushion the blow to incomes and jobs. Moving forward, continued fiscal, monetary and structural policy support will be crucial to preserving business confidence and limiting uncertainty.

In the Philippines, the government likewise acted swiftly and provided regulatory relief in aid of national healing and recovery. In the first part of this article, we will discuss the regulatory relief efforts the government provided to ease the impact of the pandemic on businesses, as well as concessions for banks and non-bank institutions and the resulting impact these have on financial reporting.

The Bayanihan to Heal as One Act (Bayanihan I) made effective on March 25 provided a minimum 30-day grace period on loan payments, without interest, penalties, or other fees charged on these payments. Six months later, the Bayanihan to Recover as One Act (Bayanihan II), which took effect on Sept. 15, doubled the grace period and increased its coverage.

Separately, the Bangko Sentral ng Pilipinas (BSP) issued Memorandum No. M-2020-074 on Sept. 28, which required all BSP-supervised financial institutions to provide a one-time 60-day grace period for all existing, current and outstanding loans with principal and/or interest, with amortization falling due between Sept. 15 and Dec. 31 without incurring additional interest, penalties, fees, or other charges. The principal and accrued interest for the 60-day grace period may be paid in installments until Dec. 31 or as may be agreed upon by the involved parties.

Other government support included the lowering of effective lending interest rates and reserve requirements, a three-year repayment term, and no collateral for loans below P3 million; conditional loan interest rate subsidies for affected learning institutions; and an increase in maximum loan amounts per borrower, reduced interest rates, and extended loan terms for micro, small and medium enterprises (MSMEs), cooperatives, hospitals, tourism companies and overseas workers affected by the pandemic.

The government also initiated a low interest and/or “flexible term” loan program for operating expenses for businesses affected by the pandemic and provided guarantees for non-essential businesses. Moreover, it liberalized the grant of incentives for the manufacture or import of critical or needed equipment or supplies or essential goods, and provided a loan interest rate subsidy to critically-impacted businesses.

The general loan loss provision, which is part of a bank’s Tier 2 capital, is limited to 1% of a banks’ credit risk-weighted assets such that any excess amount will be considered in computing risk-based capital ratios. Non-bank financial institutions (NBFI) are also required to set up an allowance for credit losses and to report non-performing loans.

Bayanihan II and BSP Memorandum No. M-2020-074 provides certain reliefs to banks and NBFIs in regard to the mandatory grace period to borrowers. These include the staggered booking of allowances for credit losses, with banks and NBFIs given the option to insulate net earnings and capital from the effects of higher credit risk, cushioning the banks and NBFI’s net earnings and capital; exemption of borrowers availing of the mandatory grace period from the limits on real estate loans when applicable, and from related party transaction restrictions, which gives the banks and NBFIs more opportunity to extend financial assistance to those affected by the pandemic; and non-inclusion in the bank’s or NBFI’s reporting on non-performing loans, reducing the regulatory burden on lenders as they extend more loans and restructure facilities of financially-burdened borrowers.

These concessions are necessary to avoid putting pressure on any one sector of society, especially on sources of finance. They also ensure that policies to achieve recovery are sustainable in the long run.

As financial institutions and corporations implemented the provisions of Bayanihan I and II, scheduled repayments under the loan and lease agreements were changed to reflect the grace period. Furthermore, borrowers and lessees may potentially negotiate further with lenders and lessors on concessions and forbearance that may significantly change the original terms of their arrangements.

In such cases, companies will need to refer to the guidance provided under Philippine Financial Reporting Standard (PFRS) 9, Financial Instruments and PFRS 16, Leases to consider the potential accounting implication of such changes in contractual provisions.

For loan agreements, the key consideration is to assess whether the changes represent a substantial modification or a potential contract extinguishment.

For borrowers, PFRS 9 provides guidance on determining if a modification of a financial liability is substantial. This includes a comparison of the cash flows before and after the modification, discounted at the original effective interest rate (EIR) commonly referred to as the “10% test.” If the difference between these discounted cash flows is more than 10%, it is considered a substantial modification, and the existing financial liability is derecognized.

However, other qualitative factors could lead to derecognition irrespective of the 10% test (e.g., if a debt is restructured to include an embedded equity instrument). If the change results in extinguishment of cash flows, the financial liability should also be derecognized. This is the case when the obligation specified in the contract is discharged, canceled or expires.

The effect of derecognition of existing financial liability will result in extinguishment gain or loss recognized in profit or loss. For substantial modifications, a new financial liability is to be recognized based on the revised cash flows using the current EIR. Thus, interest expense will be based on the new EIR moving forward. While most of the renegotiations may result in an extinguishment gain to borrowers, future net earnings will be affected by the change in the interest expense based on the new EIR.

From the perspective of lenders, there is no explicit guidance in PFRS 9 for when a modification should result in derecognition. Hence, entities apply their own accounting policies, which are often based on qualitative considerations and, in some cases, include the 10% test. It should be noted though that the International Financial Reporting Standard (IFRS) Interpretations Committee has indicated that applying the 10% test in isolation would not always be appropriate because of potential inconsistencies with the impairment requirements in IFRS 9 (the international standard equivalent of PFRS 9).

Some preparers of financial statements may apply different accounting policies depending on whether a modification is granted due to the financial difficulty of the borrower, with some concluding that such a circumstance would rarely result in the derecognition of the financial asset. If a measure provides temporary relief to debtors and the net economic value of the receivable is not significantly affected, the modification is not likely to be considered substantial. For example, if the payment terms of a receivable are extended from 90 days to 180 days, this change on its own would likely not be considered a substantial modification of the receivable.

If, following the guidance above, a modified financial asset or liability is not considered a substantial modification, such does not result in derecognition. The original EIR is retained and there is a catch-up adjustment to profit or loss for the changes in expected cash flows discounted at the original EIR. The impact of such is much less compared to when the modification of financial asset or liability is considered substantial. For floating rate instruments, a change in the market rate of interest is prospectively accounted for. However, any other contractual change (e.g., the spread applied above the interest rate) would also result in a catch-up adjustment at the date of modification.

It is expected that the changes in contractual cash flows that are solely based on the provisions of Bayanihan I and II will result in a non-substantial modification. However, companies should assess if there are further renegotiations and forbearances that should be considered.

In the second part of this article, we will discuss how to assess lease modifications in relation to the COVID-19-related Rent Concessions Amendment to PFRS 16, and our insights on accounting for rent concessions.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Rosalie T. Lapuz is a Tax Senior Manager and Leomar G. Velez is an Assurance Senior Manager from SGV & Co.

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