"Variable" interest bearing financial instruments

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Porus
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"Variable" interest bearing financial instruments

Post by Porus »

A bank loan is taken, on Islamic Murabaha terms, where the stated rate of interest is the 3month EIBOR+3% - so apparently a variable interest rate. The loan is for an amount of AED 180 Million, which will be repaid over approximately 6 years, in 22 quarterly instalments of AED 8,181,818 each. The interest on this loan is calculated by the bank at AED 2.67 Million, which is not clear how they have arrived at the amount. But if we take that as a given for the moment. This entire interest of 2.67M is to be paid upfront, by the borrower to the bank, 6 months after availing the loan, and then the 22 quarterly repayments of principal will start.

Although the loan is, on paper, a variable rate financial liability, I do not see the borrower's cashflows varying in any way. His payouts are all fixed - 2.67M to be paid 6 months after availing the loan, and then 8.1M to be paid quarterly, for 22 quarters.

Would you regard this as a fixed rate liability, in substance, and calculate the FV of the loan at inception, using an effective interest rate (EIR), or would this be a variable rate one ? I did a rough working to arrive at an EIR, and 3% p.a. appears to be the EIR, which almost exactly discounts the cashflows to zero at the end of the loan term.
JRSB
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Re: "Variable" interest bearing financial instruments

Post by JRSB »

Sounds like it's fixed if there's no mechanism to recover/pay more if EURIBOR moves in the period.

I guess it's an Islamic banking thing... maybe there's specific guidance for Islamic banking arrangements?
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Marek Muc
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Re: "Variable" interest bearing financial instruments

Post by Marek Muc »

I would try to clarify with the bank or treasurer at the company how exactly the cash flows work

your assumption is that interest is paid upfront and then only the face value is repaid right? this works like a zero-coupon bond, so cash actually received will be the initial recognition amount, and then you will accrue interest using the effective interest method so that you'll end up with the face value at repayment date
https://ifrscommunity.com/knowledge-bas ... rest-rate/
JRSB
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Re: "Variable" interest bearing financial instruments

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Interesting (and fairly short) read. https://www.pwc.co.uk/assets/pdf/open-t ... d-ifrs.pdf
Porus
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Re: "Variable" interest bearing financial instruments

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Yes I was thinking of the zero-coupon bond, but the only thing is that the repayment is happening in equal instalments throughout the term of the loan, such that, the amount to be paid at the end of the loan term is not the principal + interest. To recap the figures:
they get the loan of 180M
pay out the interest upfront 2.67M to the bank
pay 22 equal quarterly instalments of 8.1M to the bank.
This makes it a total payout of 182.67M.
They are not repaying 182.67M in one go, at the end of the loan term.

The company accountant has since confirmed that even if the interest rate benchmark (EIBOR in this case) varies, their cashflows will not change - they are contractually bound to pay 2.67M upfront, which they already have, and then 8.1M in 22 equal quarterly instalments.

So, this should be a fixed rate financial liability, and the difference between the FV and the transaction price (180M), would be deferred and amortised on a straight-line basis over the loan term - would that appear to be the most appropriate analysis of the situation ?

The PWC document is insightful!
JRSB
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Re: "Variable" interest bearing financial instruments

Post by JRSB »

Is there some other explanation of the extra 2.67M, since the 'interest' is paid up front?
pub_acco
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Re: "Variable" interest bearing financial instruments

Post by pub_acco »

Perhaps you need to calculate an effective interest rate based on a cash flow projection like this?

Q0: 180
Q1: (8.18)
Q2: (8.18) + (2.67)
Q3 thru Q22: (8.18)

The straight-line method might be inappropriate because the principal is considerably different at the 1st quarter and the 22nd quarter.
pub_acco
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Re: "Variable" interest bearing financial instruments

Post by pub_acco »

Oops the above cash flow is wrong because you told the quarterly payments start after the initial 6 months. Anyway, if you can project cash flows then you can calculate an EIR using Excel.
Porus
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Re: "Variable" interest bearing financial instruments

Post by Porus »

Agree, cashflow projections are fairly clear, and EIR comes to around 3%
pub_acco
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Re: "Variable" interest bearing financial instruments

Post by pub_acco »

Then, you can calculate the interest expenses of each quarter by multiplying the principal and EIR, can't you? The interest expenses increase the carrying amount of the loan, the repayments (including the 2.67M "interest") decrease it, and as a result the carrying amount will be zero after six years if your EIR calculation is correct :)
Porus
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Re: "Variable" interest bearing financial instruments

Post by Porus »

Yes certainly, that is what would be done. My query was more about confirming my understanding that although on paper it was a variable rate loan, in substance, it was a fixed-rate loan
pub_acco
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Re: "Variable" interest bearing financial instruments

Post by pub_acco »

I'm curious too :) Some web sites indicate that only fixed-rate loans can be structured under Murabaha but I have absolutely no experience on Islamic financing.
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Re: "Variable" interest bearing financial instruments

Post by JRSB »

Can you rely on the 'company accountant' confirming that a variation in interest rates won't be applied? If the loan agreement doesn't say that, perhaps you have to assume it's variable, unless you have experience of these things?
Porus
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Re: "Variable" interest bearing financial instruments

Post by Porus »

True, the first quarterly instalment is due in about 2 month's time, so I should be able to corroborate by then
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