Modification of Terms of an existing financial liability

Accounting for the modification of terms of an existing financial liability involves recognizing and
measuring the impact of changes to the terms of a debt arrangement.

Identification of Modification:

Determine whether there has been a modification to the terms of the financial liability. A modification
occurs when there is a change in the contractual cash flows, such as a change in interest rate, maturity
date, or other terms.

Accounting Treatment for Modifications:

If the modification results in a substantial change in the cash flows, it is accounted for as an
extinguishment of the original liability, followed by the recognition of a new liability.
If the modification is not substantial, the existing liability is adjusted to reflect the revised cash flows.

Fair Value Measurement:

Assess the fair value of the modified liability. This may involve estimating the present value of future
cash flows using the current market interest rates for similar financial instruments.

Gain or Loss Recognition:

Recognize a gain or loss on the modification if the fair value of the modified liability is different from
the carrying amount of the original liability. This gain or loss is recorded in the income statement.

Adjustment to Carrying Amount:

Adjust the carrying amount of the modified liability to its new present value, incorporating the revised
cash flows and any related transaction costs.

Amortization of Adjustments:

Amortize any adjustment made to the carrying amount over the remaining term of the modified
liability using the effective interest rate method.

Disclosure:

Disclose the nature and extent of the modification, the reasons for it, and the financial impact in the
financial statements. This provides transparency to financial statement users.
It's essential to follow accounting standards and principles, such as those outlined in International
Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), to
ensure proper and accurate reporting of modifications to financial liabilities.

Sample problem:
Company ABC issued a $500,000, 5-year loan with an annual interest rate of 10%. After two years,
due to financial difficulties, the company and the lender agree to modify the loan terms. The new
terms include a reduced interest rate of 8% and a grace period of one year during which no interest
will accrue. The remaining maturity of the loan is extended by two years. The original effective
interest rate was 10%.

Requirements:
Determine whether the modification is substantial and, if so, provide the necessary accounting
entries.