Interest Rate Cap

[Nicole0907]

Hi, please can you help with the simplest way to account for an interest cap under IFRS?

Initially we had expensed the premium up-front, however should this actually be held on the balance sheet and released over time? We are essentially looking for the simplest way of accounting for this, so will likely not opt for hedge accounting (assuming this is acceptable under IFRS 9?). Please can you advise if the following methods are acceptable, or if there is anything else I should consider?

1)
- Expense premium up-front to P&L - Dr expense and Cr cash
- If cap pays out, this is a Cr to the interest expense and Dr to cash.
- No balance sheet impact at all.

2)
- Premium initial recognition of Dr asset and Cr cash
- No FV adjustments
- Premium is amortised over length of cap (3 years) on a straight line basis so it is 0 after 3 years - Dr expense and Cr asset every month
- If cap pays out, Cr interest expense and Dr cash.

Any help would be appreciated, as its difficult to find specific guidance for this online, thanks!

[JakobLavrod]

When you say that you have an interest rate cap, do you mean that you have purchased a derivative that starts to pay out if the interest rate exceed a certain level? If it is a derivative, you should account for it at fair value at each reporting date then right?

[Nicole0907]

Hi, yes this is what I mean, however when I look at guidance, the fair value requirement seems to only apply if you are applying hedge accounting, which I am hoping to avoid. IFRS 9 seems to state this is optional, so want to check if either of the two options above are correct in this instance.

[JakobLavrod]

Hedge accounting is option, but derivatives must always be accounted for at fair value through PnL since they fail SPPI, so you will have to fair value account each period. I have very limited experience of what is an acceptable approximation, so will have to defer to someone else here

[Nicole0907]

Hi Jakob - thanks so much! So essentially option 1 is completely irrelevant as the cap has to be accounted for on the balance sheet regardless of hedge accounting or not. Option two is ok, I just need to amend the second step to adjust FV? Does step 3 then change so the amortisation is recalculated each month for the updated FV amount?

If anyone has any advice on how the FV adjustment is calculated that would be great as well please?

1)
- Expense premium up-front to P&L - Dr expense and Cr cash
- If cap pays out, this is a Cr to the interest expense and Dr to cash.
- No balance sheet impact at all.

2)
- Premium initial recognition of Dr asset and Cr cash
- No FV adjustments
- Premium is amortised over length of cap (3 years) on a straight line basis so it is 0 after 3 years - Dr expense and Cr asset every month
- If cap pays out, Cr interest expense and Dr cash.

[Ketan Marwah]

Hi,

You don’t amortize derivative but a derivative contract is settled at a future date, regardless of whether the settlement is on a gross or net basis (IFRS 9.IG.B.3). The expiration of an unexercised option also constitutes a form of settlement (IFRS 9.IG.B.7). Make the changes therefore to the fair value subsequently and settle it eventually.

[Nicole0907]

There is no contract settlement though. There is a premium paid upfront and then only any further payments if the interest charge for the loan goes above what the cap rate states. If this doesn’t happen then no other settlements exist. Everything I’ve read seems to state you release the asset over the life of the interest cap contract. Is this not correct?

[Ketan Marwah]

Hi,

I am not sure what source are you referring to but there is no derivative without having to be settled in future. If what you want to convey is that for the premium you have paid you wouldn’t get anything back then include that assessment in your fair value measurements of the derivative as a whole and route the adjustments through PnL in the subsequent measurement. You don’t have to stagger the adjustments over the contract term.

Refer

https://ifrscommunity.com/knowledge-bas ... rivatives/

[Nicole0907]

Thanks for your help so far. I’m slightly confused what you mean as I never specifically called it a derivative. The whole setup of an interest rate cap is you pay an upfront premium (in this case £500k), then for the length of the agreement (3 years) if the interest I owe on a separate loan exceeds the rate in the interest rate cap contract of 4%, I get a payout. So if the next interest statement I get for the loan is 6%, the interest cap pays me the 2% difference (6% - 4%). If interest never exceeds 4%, then I receive nothing at all from the cap going forward. There is no settlement.

[Ketan Marwah]

Hi,

I am sorry but it would be tough for me to continue to discuss this unless you invest some time in understanding the instrument better.
An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. In your chat with Jakob you agreed to that understanding too.
Maybe someone else might want to pitch in but my suggestion would be that you read about the topic a bit more and revert with questions, if any. Best of luck.

[Nicole0907]

Hi Ketan, yes I know, that is exactly what I have stated in my response to you. However you are stating there is a guaranteed settlement at the end of the agreement which I am saying is not correct.

[Nicole0907]

Just to add - this is the source I am referring to that says you are to amortise the interest cap, which you have said is not the correct process. See the ‘time period’ example in the link below.

https://ifrscommunity.com/knowledge-bas ... ccounting/

[Ketan Marwah]

You mentioned in your previous post when talking with Jakob that you are not applying hedge accounting or at-least don’t intend to where he explained that it is optional.
Let me start from the beginning then before we get to journal entries. Have you designated either the full, or the intrinsic, value of the cap as a hedging instrument?

[JakobLavrod]

On the question on derivatives, please look here for more information:
https://en.wikipedia.org/wiki/Interest_ ... _and_floor

[Ketan Marwah]

Hi,

My suggestion would be that you first determine whether you are referring to a derivative alone OR a derivative designated as a hedging instrument.

If it is only a derivative then you have to apply the mark to market method (immediate recognition). As you are aware that if rates go above a specified interest rate level (the strike price or the cap rate), the cap holder is entitled to receive cash payments equal to the excess of the market rate over the strike price multiplied by the notional principal amount whereas if rates move down, the cap holder has lost only the premium paid therefore changes in fair value from one reporting period to another reporting period shall be recognized in PnL.

If you have designated time value of options (that is included in the option premium paid) as hedging instruments then for the time period related hedged items an entity could choose a particular amortization profile. Amortization profiles could include:
(a) linear amortization (straight-line);
(b) a differentiating approach specifying different particular amortization profiles; or
(c) a ‘rational basis’ for amortization.
This is similar to an ‘insurance premium view’ wherein the insurance premium can only be amortized as long as there is an exposure that is insured.