## Learning Outcomes

- Explain how amortised cost measurement uses the effective interest method after initial recognition.
- Identify when a modification of a financial liability leads to derecognition.
- Apply the 10% test to decide whether revised liability terms are substantially different.
- Account for non-substantial modifications of financial liabilities and financial assets.
- Explain the derecognition principles for financial assets, including risks and rewards and control.
- Explain when a financial liability is removed from the statement of financial position.
- Avoid common ACCA FR errors in modification and derecognition calculations.

## ACCA Financial Reporting (FR) Syllabus

Financial instruments in ACCA FR require both knowledge of IFRS 9 principles and the ability to perform focused calculations. Modifications and derecognition are often tested through loan notes, debt instruments, refinancing, revised payment terms, or transfers of receivables. The key exam skill is deciding whether the original instrument remains in the statement of financial position or whether it is replaced, sold, settled, or extinguished.

- Subsequent measurement of financial assets and liabilities at amortised cost.
- Use of the effective interest rate in measuring debt instruments and loan notes.
- Accounting for changes in contractual cash flows.
- Derecognition of financial liabilities when obligations are settled, cancelled, or expire.
- Derecognition of financial assets when contractual rights expire or are transferred.
- Distinguishing substantial modifications from non-substantial modifications.
- Recognising gains and losses on derecognition or modification.
- Basic IFRS 7 disclosure awareness for risks, transfers, and continuing involvement.

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What does the effective interest rate do when measuring a financial asset or financial liability at amortised cost?
2. When is a financial liability derecognised under IFRS 9?
3. How is the 10% test applied when a loan’s terms are renegotiated?
4. If revised loan terms are not substantially different, is the original liability derecognised?
5. What is the basic derecognition sequence for a transferred financial asset?

## Introduction

After initial recognition, IFRS 9 requires financial instruments to be measured in a way that reflects their classification and the entity’s rights and obligations. In ACCA FR, this usually means applying amortised cost to loan notes, debt instruments, borrowings, and some receivables or investments. The examiner often gives interest payments, redemption amounts, issue costs, or revised terms and expects candidates to apply the effective interest method correctly.

Modifications and derecognition take this further. A loan may be refinanced, a debt instrument may have its cash flows revised, receivables may be sold, or a liability may be settled early. The accounting depends on whether the original financial instrument still exists in substance or whether it has ended and a new instrument has taken its place.

> **Key Term: Derecognition**
> The removal of a recognised financial asset or financial liability from the statement of financial position.

### Amortised cost as the starting point for modifications

Many FR questions on modifications begin with an instrument measured at amortised cost. This means the carrying amount is not simply the face value, nor is it always equal to the amount payable at the reporting date. Instead, the carrying amount is built up using the effective interest method.

> **Key Term: Amortised cost**
> The amount at which a financial asset or financial liability is measured after initial recognition, adjusted for principal repayments, cumulative effective interest, and, for financial assets, impairment allowances where relevant.

For a financial liability measured at amortised cost, the basic movement is:

$$
\text{Opening carrying amount}

- \text{finance cost at effective interest rate}
- \text{cash paid}

= \text{closing carrying amount}
$$

For example, if a loan liability has an opening carrying amount of $950,000, an effective interest rate of 8%, and a cash coupon of $50,000, the closing carrying amount before any modification is:

$$
950,000 + (950,000 \times 8\%) - 50,000 = 976,000
$$

The effective interest rate is central because it spreads finance costs over the expected life of the instrument. This is why issue costs, premiums on redemption, discounts on issue, and transaction costs are not usually expensed immediately for instruments held at amortised cost. They affect the carrying amount and are reflected through the effective interest rate.

> **Key Term: Effective interest rate**
> The rate that exactly discounts estimated future cash payments or receipts over the expected life of a financial instrument to its carrying amount on initial recognition.
>
> **Test Tip:**
> In calculation questions, do not use the coupon rate as the finance cost rate unless the question says it is also the effective interest rate. The coupon rate calculates cash interest; the effective interest rate calculates finance income or finance cost.

A modification changes the contractual cash flows or terms of a financial instrument. For example, a lender may agree to reduce interest, extend the repayment date, waive part of the principal, or replace a fixed rate with a different rate. The accounting issue is whether this is a change to the existing instrument or the end of the old instrument and recognition of a new one.

> **Key Term: Modification**
> A change to the contractual terms or cash flows of a financial asset or financial liability.

### Financial liability modifications and the 10% test

A financial liability is derecognised when the obligation is discharged, cancelled, or expires. This is clear when a loan is repaid in cash. It can be less obvious when a loan is renegotiated. IFRS 9 treats an exchange of debt instruments, or a modification of terms, as an extinguishment of the old liability if the terms are substantially different.

> **Key Term: Financial liability extinguishment**
> The ending of an existing financial liability because the obligation has been discharged, cancelled, expired, or replaced by substantially different terms.

For financial liabilities, a practical test often used in FR questions is the 10% test. The revised terms are substantially different if the present value of the cash flows under the new terms, including fees paid net of fees received between the borrower and lender, discounted using the original effective interest rate, differs by at least 10% from the carrying amount of the original liability.

> **Key Term: 10% test**
> A test used for financial liabilities to assess whether revised terms are substantially different by comparing the present value of revised cash flows, discounted at the original effective interest rate, with the carrying amount of the original liability.

The comparison can be expressed as:

$$
\frac{
|\text{PV of revised cash flows at original EIR} - \text{carrying amount of original liability}|
}{
\text{carrying amount of original liability}
}
\times 100\%
$$

If the result is 10% or more, the modification is substantial. The old liability is derecognised and a new liability is recognised. Any difference between the carrying amount of the old liability and the fair value of the new liability, adjusted for relevant consideration, is recognised in profit or loss.

If the result is less than 10%, the modification is not substantial. The original liability remains in the statement of financial position. The carrying amount is adjusted to the present value of the revised cash flows discounted at the original effective interest rate, and the resulting modification gain or loss is recognised in profit or loss.

> **Exam Warning:**
> A common mistake is to discount the revised cash flows at the new interest rate when applying the 10% test. Use the original effective interest rate for the test and for remeasuring a non-substantially modified liability.

Consider a liability with a carrying amount of $1,000,000. The borrower and lender agree revised payments with a present value of $925,000 when discounted at the original effective interest rate. The difference is $75,000, or 7.5% of the carrying amount. This is below 10%, so the liability is not derecognised. The borrower adjusts the carrying amount to $925,000 and recognises a gain of $75,000 in profit or loss.

Now assume the revised cash flows have a present value of $880,000 using the original effective interest rate. The difference is $120,000, or 12%. The modification is substantial. The old liability is removed, a new liability is recognised, and the gain or loss on extinguishment is recorded in profit or loss.

> **Question:**
> A company has a financial liability with a carrying amount of $500,000. The lender agrees to revised terms. The present value of the new cash flows, discounted at the original effective interest rate, is $456,000. Is the modification substantial?
The difference is:

$$
500,000 - 456,000 = 44,000
$$

The percentage difference is:

$$
44,000 / 500,000 = 8.8\%
$$

The modification is not substantial. The liability is not derecognised. The carrying amount is adjusted to $456,000 and a gain of $44,000 is recognised in profit or loss, before considering any transaction costs or fees.

Fees can affect the accounting. If a liability is derecognised because the change is substantial, fees paid in relation to the extinguishment form part of the gain or loss on extinguishment. Fees related to the new liability are usually included in the measurement of that new liability if it is measured at amortised cost. If the change is not substantial, fees adjust the carrying amount of the continuing liability and are spread using the effective interest method.

### Derecognition of financial assets

The derecognition rules for financial assets are based on contractual rights, transfer of risks and rewards, and control. The first question is whether the contractual rights to the cash flows have expired. For example, a bond reaching maturity and being repaid is derecognised because the holder’s right to receive future cash flows has ended.

If the rights have not expired, the next question is whether the asset has been transferred. A transfer may occur when the entity transfers the contractual rights to receive the cash flows, or when it keeps the legal right to receive cash flows but accepts an obligation to pass those cash flows on to another party.

Once a transfer has occurred, IFRS 9 focuses on risks and rewards:

- If substantially all risks and rewards of ownership have been transferred, derecognise the financial asset.
- If substantially all risks and rewards have been retained, continue to recognise the financial asset.
- If neither transferred nor retained, assess whether control has been retained.
- If control has not been retained, derecognise the asset.
- If control has been retained, continue to recognise the asset to the extent of continuing involvement.

> **Key Term: Risks and rewards**
> The exposure to variability in the amounts and timing of cash flows from a financial asset, such as credit risk, late payment risk, or price risk.
>
> **Key Term: Continuing involvement**
> The extent to which an entity remains exposed to changes in value or cash flows of a transferred financial asset after transfer.

Receivables factoring is a useful exam example. If a company sells receivables to a finance provider without recourse, and the finance provider bears the risk of customer default, the company is more likely to have transferred substantially all risks and rewards. Derecognition may be appropriate.

By contrast, if the company factors receivables with full recourse, meaning it must compensate the finance provider if customers fail to pay, the company has retained significant credit risk. The receivables are likely to remain in the statement of financial position, and the cash received is treated as a liability rather than sale proceeds.

> **Test Tip:**
> In FR written explanations, link your conclusion to the specific risk retained or transferred. For receivables, credit risk is often the key point. For debt securities, interest rate risk and market price risk may also matter.

If a financial asset measured at amortised cost is modified but not derecognised, the accounting mirrors the logic used for liabilities. The gross carrying amount is recalculated as the present value of the modified contractual cash flows discounted at the original effective interest rate. The difference between the previous gross carrying amount and the recalculated amount is recognised as a modification gain or loss in profit or loss. Expected credit loss accounting continues to apply where relevant.

Financial asset modifications can occur when a lender grants a borrower a concession due to financial difficulty, such as reduced interest or an extended repayment period. In such a case, the lender must assess whether the modification is so significant that the original asset should be derecognised. If not, a modification loss is likely because the revised cash flows have a lower present value.

For example, a lender holds a loan asset with a gross carrying amount of $300,000. Due to the borrower’s financial difficulty, the lender agrees to accept lower future payments with a present value of $260,000 discounted at the original effective interest rate. If the asset is not derecognised, the lender records a modification loss of $40,000 in profit or loss.

### Presentation, disclosure, and exam technique

Gains and losses from derecognition or modification are normally recognised in profit or loss. In FR, the key is to identify the correct point in the calculation:

- update the carrying amount to the modification date if needed;
- decide whether derecognition applies;
- calculate the gain or loss;
- recognise any new financial asset or liability at the correct amount;
- continue applying the effective interest method after the event.

IFRS 7 supports IFRS 9 by requiring disclosures about the significance of financial instruments and the nature and extent of risks arising from them. In exam questions, this may be relevant where assets have been transferred but the entity has continuing involvement, or where liabilities have been renegotiated. The accounting entries are usually the main focus in FR, but brief disclosure comments can earn marks in narrative parts.

> **Key Term: IFRS 7 disclosure**
> Information provided in the financial statements about the significance of financial instruments and the risks arising from them.

For a derecognised financial liability, the gain or loss is generally:

$$
\text{Carrying amount of liability extinguished}

- \text{Consideration paid}

= \text{gain or loss}
$$

If the consideration paid is less than the carrying amount, there is a gain. If the consideration paid is more than the carrying amount, there is a loss.

For example, a company repays a loan early for $970,000 when its carrying amount is $1,020,000. The company derecognises the liability and recognises a gain of $50,000 in profit or loss:

$$
1,020,000 - 970,000 = 50,000
$$

For a transferred financial asset, the gain or loss is based on the difference between the carrying amount derecognised and the consideration received, adjusted for any new asset or liability recognised as part of the transfer. At FR level, questions often keep this simple, but candidates should still think carefully about whether recourse terms or guarantees prevent derecognition.

> **Exam Warning:**
> Do not assume that receiving cash always means a financial asset has been sold. If the entity keeps the main risks, the transaction may be a secured borrowing rather than derecognition of the asset.

A sound exam approach is:

1. Identify the instrument: asset or liability.
2. Identify its measurement basis, usually amortised cost in FR calculations.
3. Bring the carrying amount up to date using the effective interest method.
4. For a liability modification, apply the 10% test if relevant.
5. For an asset transfer, assess expiry, transfer, risks and rewards, then control.
6. Record the gain or loss in profit or loss.
7. Carry forward the remaining or new instrument using the effective interest method.

Short objective test questions may ask for one number, such as the carrying amount of a loan note after two years or the gain on settlement. Longer questions may combine financial instruments with other areas, such as revenue, provisions, or statement of cash flows. Always label workings clearly: coupon interest, effective interest, cash repayment, carrying amount, present value, and gain or loss.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Amortised cost uses the effective interest method, not simply the coupon rate.
- The effective interest rate discounts expected future cash flows to the instrument’s carrying amount.
- A financial liability is derecognised when the obligation is discharged, cancelled, or expires.
- A substantial modification of a liability is accounted for as extinguishment of the old liability.
- The 10% test compares the present value of revised cash flows, discounted at the original effective interest rate, with the old liability’s carrying amount.
- A non-substantial liability modification does not lead to derecognition.
- Non-substantial modifications are recorded by remeasuring the carrying amount and recognising a gain or loss in profit or loss.
- Financial assets are derecognised when contractual rights expire or when transfer tests are met.
- For transferred financial assets, assess risks and rewards before considering control.
- If significant risks are retained, cash received may be treated as a liability rather than sale proceeds.
- Continuing involvement may require partial recognition of a transferred financial asset.
- IFRS 7 disclosures explain the significance and risks of financial instruments, including transfers and continuing involvement.

## Key Terms and Concepts

- Derecognition
- Amortised cost
- Effective interest rate
- Modification
- Financial liability extinguishment
- 10% test
- Risks and rewards
- Continuing involvement
- IFRS 7 disclosure


Subsequent measurement and derecognition - Modifications and derecognition principles